When reading Seeking Alpha Friday, I couldn’t help noticing that the most popular article was: Why the Stock Market Should Crash, by Charles Hugh Smith. With all due respect to Mr. Smith, and all the other doomsayers out there, I frankly just don’t get it. In my opinion, fear is a negative emotion that causes more harm than good. My favorite acronym for FEAR is: False Evidence Appearing Real.
People who are worried about whether the stock market will crash or not are worried about a generality. In contrast, the world’s most successful investors are known to deal solely with specifics. Investing giants like Warren Buffett and Peter Lynch are on record as ignorers of the general stock market. Instead, they are only interested in the specific companies they own.
Regarding the stock market, there is also a lot of talk about the so-called “Lost Decade”. I will use the S&P 500 since calendar year 2000 as my proxy for the “Stock Market”, and its dreadful decade in this article. However, my contention is that unless you have all your liquid assets invested in the S&P 500 or some other passive index fund, the general market should be of little concern.
In Figure 1 below, we show the S&P 500 correlated to its earnings since 12/31/1999 to include performance. There are three key factors that are obvious from this graph:
- On 12/31/1999 the S&P 500 was at 1469 (green arrows) and was overvalued trading at more than 26 times earnings of $55.83 (red arrow.) Therefore, since the normal P/E ratio of the S&P 500 has been 17.5 for the past 20 years, future poor performance should have been expected.
- The rate of change of earnings growth for the S&P 500 of 2.9% (Red circle), was not strong enough to generate a positive return from such a lofty valuation.
- From calendar year 2000 to the current, we suffered through two recessions which created above-average cyclicality of earnings for the S&P 500. Clearly, earnings drive the long-term movement of stock price.
Figure 1 S&P 500: EPS Growth Correlated to Price and Price Performance
In his runaway national bestselling book "One Up on Wall Street", Peter Lynch devoted Chapter 5 to the thesis of my article titled “Is this a Good Market? Please don’t ask.” Mr. Lynch clearly and eloquently expressed his disdain for attempting to forecast the stock market. The following snippets from Chapter 5 illustrate the point:
“If you must forecast,” an intelligent forecaster once said, “forecast often.”
What Stock Market?
The Market ought to be irrelevant. If I could convince you of this one thing, I’d feel this book had done its job. And if you don’t believe me, believe Warren Buffett, “As far as I am concerned,” Buffett has written, “the stock market doesn’t exist. It is only there as a reference to see if anybody is offering to do anything foolish.”
Finally Mr. Lynch added:
I’d love to be able to predict markets and anticipate recessions, but since that’s impossible, I’m satisfied to search out profitable companies as Buffett is. I’ve made money even in lousy markets, and vice-versa. Several of my favorite tenbaggers made their biggest moves during bad markets.
In the long run, earnings determine market price, and valuation plays a prominent role. Utilizing our Fundamentals-at-a-Glance research tool, I offer the following examples that validate the thesis and premises of this article. I will illustrate some stalwart like, solid growing businesses, and will sprinkle in a few powerhouse fast growers. Then I will add two examples of how overvaluation impacted returns even when earnings growth was strong.
I start with Nike (NKE), Figure 2. Note that Nike’s stock price (black line) starts out slightly above the earnings line (green line with white triangles) implying modest overvaluation. However, earnings growth of 13.4% translates into annual 10% appreciation (excluding dividends) compared to a minus 2.9% annual loss for the S&P 500, or the stock market.
Figure 2 NKE: EPS Growth Correlated to Price and Price Performance
In Figure 3 we feature Cognizant Technologies Solutions (CTSH) a fast-growing outsourcer that has no debt and an earnings growth rate of almost 40% (39.8%). Clearly, the stock market had absolutely nothing to do with the returns that Cognizant shareholders enjoyed.
Figure 4 features TEVA Pharmaceutical Industries (TEVA), an Israel based ADR, the largest generic drug developer in the world. With earnings growth over 29% per year, TEVA shareholders enjoyed annual appreciation of almost 20% even though their stock price (black line) is currently at a discount to earnings (green line with white triangle). Once again, the stock market didn’t matter to TEVA Shareholders.
Figure 4 TEVA: EPS Growth Correlated to Price and Price Performance
Figure 5 features ITT Educational Services, Inc. (ESI). Strong earnings right through the recession rewarded shareholders far in excess of the general stock market.
Figure 5 ESI: EPS Growth Correlated to Price and Price Performance
Figure 6 features Coach Inc. (COH) where 30% growth of earnings translates into a similar shareholder return, regardless of the bad market. Note that both Coach and the S&P 500 are measured only from October of 2000 because Coach was not a public company in 1999.
Figure 6 COH: EPS Growth Correlated to Price and Price Performance
Figure 7 features Google, Inc. (GOOG) and only has a track record since going public in 2004. However, once again, there is no correlation or relationship to Google shareholder results and the stock market (S&P 500).
Figure 7 GOOG: EPS Growth Correlated to Price and Price Performance
Figures 8 and 9 are offered to illustrate the importance of valuation. Both Procter & Gamble Co. (PG), a Peter Lynch stalwart, and Oracle (ORCL), a faster-growing technology company suffered from overvaluation at the beginning of the period. Both of these companies generated returns that were closer to the general stock market. However, it was overvaluation and not the market that affected their respective results.
Figure 8 PG: EPS Growth Correlated to Price and Price Performance
Figure 9 ORCL: EPS Growth Correlated to Price and Price Performance
These are but a few examples of many that could be offered. Remember the stock market is about averages, and as Warren Buffett also said "Who wants to be average?" It is better to focus on what you own and not worry about things you don't. I believe you will find this to be more peaceful and profitable, in the long run.
We, like Peter Lynch and Warren Buffett, believe that all the fuss about what the stock markets in general may or may not do is unwarranted, assuming - of course - that valuation is in line with cash flows. At the end of the day, we feel that all it does is take the investor's eye off the critical ball of what they actually are invested in. Wall Street may climb a wall of worry, but good businesses climb a wall of business success, more commonly known as earnings. Therefore, what the stock market may or may not do really shouldn’t matter to the serious long-term fundamental investor.
Disclosure: Long NKE, ESI, CTSH, TEVA, GOOG, COH, ORCL, PG at time of writing.
The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.