What drives stock prices?

What drives stock prices? At times like this, this question is crucial for investors to understand. The answer is that when you really get down to it, stock prices are really determined by only two things:

1. Fundamentals of a business – Earnings per share, cash flow, return on invested capital, etc.
2. Sentiment – How much the market is willing to pay for those fundamentals in the form of a multiple, discount rate, etc.

Right now, many companies have great fundamentals: they’re growing earnings, generating cash, able to protect against inflation (see our recent article on this), and as such are becoming more valuable as businesses. (note- there are also many companies with poor or deteriorating fundamentals).

Regardless of fundamentals, sentiment has turned hugely negative this year- the ‘market’ has decided to mark down those very same companies that may in fact be growing in real value. To understand this, lets walk through a simple model to highlight the difference between fundamentals and sentiment.

Lets say a company is going to generate $2 in earnings per share next year, and that those earnings will continue to grow into the future as the company gets bigger and more successful. Those are the fundamentals. And let’s assume the market is willing to pay 20x one year’s earnings for the company (mathematically equivalent to using a 5% discount rate, for those of you who are so inclined). That is the sentiment. Combine the two ($2 in earnings x 20x earnings multiple) and the stock price would be $40.

So, we buy at $40 and get our 5% earnings yield ($2 earnings on $40 stock price). Simple enough right? Unfortunately, not. The fundamentals may be consistent in our example, but the sentiment side of the equation is unpredictable and volatile in reality. Whether a stock trades at a 20x or a 10x multiple is decided by thousands of market participants (and algorithms) who are known for acting irrationally – they herd, panic, get overly greedy, get overly fearful, and generally do a poor job of determining actual value in the short term.

Lets say the market gets panicky and decides our $2 earnings stream is now only worth 10x rather than 20x. There are a lot of reasons this could be the case – maybe the market doesn’t think that $2 earnings is sustainable long term, or maybe the market is worried about inflation, or maybe that company or ‘style’ is just out of favor this month. Or maybe there are so many people investing passively that multiples are getting forced in one direction by the sheer weight of the flows. For whatever reason, we just lost 50% on our fundamentally certain investment.

We have two options at this point:

1. Attempt to try to forecast the mood of the market, predicting when the market will wake up sad or happy, and capitalize on that by trading in and out of the market: buy at 10x, sell at 20x valuations. This is known as short-term trading, and as you can imagine is next to impossible to do consistently (despite how many people and firms claim that they can).
2. We ignore sentiment altogether and focus exclusively on the fundamentals. This is called long-term investing – i.e. if we know we are going to get that $2 per year in earnings (and it’s growing), it doesn’t really matter if our $40 investment turns into a $20 investment in the short term, we will continue to get that $2 every single year, and over time that $2 will grow to $3, then $4 and so on. Over time our returns will still be very good.

Long-term investors have a huge advantage in the market since they can focus on the knowable fundamentals of an investment and largely ignore the unknowable sentiment side of the equation. If we can find companies that are highly likely to produce 10%+ earnings growth for decades to come, it doesn’t matter if the multiple gets cut in half from one year to the next, as we’ll still make a great return over a decade. And in fact, when those multiples do get cut in half, that becomes a huge buying opportunity for us.

So, the question for long-term investors becomes: how do we consistently pick companies that will be able to grow earnings over long periods of time? We have written on this topic extensively, and won’t labor the point here, but it’s not easy and it takes a lot of work. But the work has huge value- because it is only when an investor has done this work that they will be able to know whether the market’s price fluctuations are simply due to short-term sentiment shifts, or if something has fundamentally changed with the investment thesis. If nothing has changed at the business but the stock price is down 30%, then you’re being offered the same high-quality asset for 30% less- and that is a huge opportunity.

The market has fallen a lot this year, and that is always uncomfortable for investors in the short term, but it’s precisely times like this that are significant opportunities. There are many companies we own where the business itself is fundamentally and objectively worth more today than it was a year ago, yet the stock price has fallen significantly (GFL, Amazon, Ocado, Copart etc). Such dislocations present a great opportunity for us as investors. So we have been adding to these positions- buying secure earnings streams at much lower prices. Finance textbooks and investment risk models will tell you stocks are riskier when they fall- in reality the opposite is true. The less you have to pay for something, the less risk you take in owning it. Yes the stock market may go lower from here in the next few months (not a human alive knows whether it will or not), but we are focused on company earnings and business value over years not months, because that is what drives real long- term investment returns.