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As an investor, it is important to know how to approach the markets in the most rational way possible. The stock market and its main proponent, Wall Street, are not always rational. Wall Street is referred to as the investment community that includes the stock exchanges, investment banks, brokers and analysts. Wall Street’s verdict on a company greatly impacts how the market values its stock. Institutional and retail investors, such as college students, are usually swayed by Wall Street’s market sentiment. If investors can distinguish when the markets act irrationally, they will find many investment opportunities.
The market, along with brokers and analysts, focuses on the short term. It values a business based on its quarter-to-quarter and year-over-year results. Businesses growing steadily quarter-to-quarter and year-over-year are praised and those missing analyst estimates are punished by the market. When business cycles and economic recessions hurt a company’s profits, the market punishes its stock price. The market’s short term focus does not make sense. Value investors would argue that recessions and business cycles, though, do not always affect a company’s intrinsic value.
The value of a business is essentially the amount of cash that can be taken out of business during the remainder of its life. If business X were to produce Y amount of cash for the remainder of its life, fifty years; why should it matter if twelve or fifteen recessions occur in the meantime? If after each recession, business X is able to return to its normal profitability, as many businesses do, then its intrinsic value should be intact. The market, only focusing on the short term, punishes all businesses that miss profit estimates and it sometimes even over punishes them.
Value investors, contrarians by nature, search for businesses whose stock prices have been oversold. They then analyze the business and determine if the stock decline was merited. If they determine that in a normal environment the company they have analyzed will perform substantially better, they purchase the company’s stock. From 2002 to 2003, McDonald’s (MCD) stock price declined over fifty percent. The U.S. economy was in a recession and Wall Street was not pleased with McDonald’s management and marketing strategy. McDonald’s french fries, Big Macs and chicken nuggets still tasted the same. Instead of focusing on the recession, investors should have known that McDonald’s brand name and long term prospects were intact. McDonald’s shares are up more than three-hundred percent since their 2002 bottom, while most broad market indices have barely increased during the same period.
Not all stocks decline undeservingly. Some businesses unable to repay debt, declare bankruptcy, such as Lehman Brothers. Other businesses lose market share to competitors, such as Gateway to HP and Dell. Recessions and business downturns can create problems for business or worsen existing problems. Wall Street, though, will punish any business’ stock price if the company doesn’t meet earnings expectations. A company’s earnings are not steady in all environments, but the intrinsic value is not always affected.
The S&P 500, a broad market index, is down more than thirty percent from a year ago. The economy is heading into a recession and the credit crisis has taken a turn for the worse, but this may be a great opportunity to invest. I do not know if AIG will recover and I do not know if the U.S. Treasury’s bailout plan will work. I am certain that college students will continue shopping from Target (TGT) ten years from now, American Express card holders will spend more money fifteen years from now, McDonald’s will sell more Big Macs twenty years from now, and many more people will drink Coke (KO) well into the future. Do not mind those stocks that are praised by Wall Street, they will, more likely than not, be overvalued.
Search for those companies that have been decimated by the market and analyze them carefully.
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