It used to be a fundamental analyst’s job to value a company by studying business operations, balance sheets and the effect that predicted future trends would have on a company’s ability to generate earnings and cash flow. Technical analysts would then attempt to predict future price swings for the stock recommended by fundamental analysts by assessing crowd behavior and studying charts of short-term price movements and trading volume with no concern for the company’s fundamentals. However, the trading mentality prevalent in today’s markets has led Wall Street fundamental analysts to reach conclusions and give advice based on short-term technical analysis. Most of the remaining analysts who still reach conclusions based on long-term fundamental analysis and values have been punished by underperforming over the past year.
It is currently estimated that almost 80% of all stocks are traded electronically based on computer trading models and algorithms. Hundreds of orders are capable of being entered in a second, creating abnormal market volatility and wild swings in stock prices that have little to do with the underlying company’s long-term ability to generate excess cash flow. Most investors today, including analysts, are not paying attention to the bigger picture. The ultimate joke about the ability to trade all day is that most investors eventually get on the wrong side of trading.
A fundamental tenet of my philosophy states that the desire to be right all of the time is a serious impediment to being right over time. It can be frustrating, as most investors tend to obsess over whatever happened in the markets most recently and assume things will be that way “forever.” Most market fads and trends last longer than anticipated, but “forever” usually ends unannounced. The extreme stock price volatility currently being experienced by investors has resulted in a crisis in confidence as to whether company fundamentals have any rational relationship to market pricing. Rather than relying on a company’s normalized ability to produce free cash flow over two- to three-year periods to determine a company’s valuation, analysts are focusing on and talking about quarterly misses and beats, buying and selling before and after quarterly earnings releases. It may be counterintuitive, but the shorter the time horizon one tries to predict, the lower the probability of being right.
Despite our belief in the low probability of projecting short-term stock price movements, analysts doing fundamental research are paying little attention to long-term fundamentals and valuations. The research is heavily influenced by the fact that markets are fluctuating by hundreds of points a day, reacting to daily news.
After years of observing technical analysis, it is our opinion that few stock technicians produce research that enables investors to profit from their conclusions with enough degrees of regularity. However, we do believe that a consistent, long-term application of fundamental analysis can increase the probability of doing so to materially higher than 50%, coming close to predicting a company’s long-term intrinsic value. Long-term investors and money managers who value companies based on their ability to generate normalized free cash flow will eventually be rewarded for their patience.
We believe the current trading mentality featuring negative-biased volatile markets and the resultant loss of confidence shall eventually pass as company fundamentals and the ability to generate cash flows retake the investing spotlight. Most investors tend to be unduly influenced by the most recent positive or negative trends and believe these trends will last forever. The task of a value investor is to identify currently accepted wisdom that’s either too pessimistic, of short-term duration or just plain wrong and wait for the market pricing mechanism to re-adjust.
We firmly believe that investors and analysts who have the patience to stick to long-term fundamentals are being presented with many outstanding profit opportunities as more and more stocks prices are decoupling from a company’s ability to generate free cash flow.