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The stock market is, as most financial markets are, a large auction. Therefore, price volatility will always be an unavoidable attribute. Because investors and traders are buying and selling all day every day, stock price is in a continuous state of flux, rising and falling with each bid. As a result, the price graph on any stock over any given period of time will always be a very jagged and zigzagging picture. This constant variation in stock price can be very unnerving to many people. The following one day price graph on AmerisourceBergen (ABC), courtesy of Yahoo Finance, shows how erratic pricing can be on any given day.

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Although this may seem like we are merely stating the obvious, we believe that there is an important message here. Even though everyone knows that stock prices are constantly rising and falling, it is easy to lose one's perspective on what is really happening. Stock price volatility is the price investors must pay for the liquidity that owning publicly traded common stocks offer.

In contrast to real estate and hard assets, you can buy or sell a publicly traded stock virtually instantly. And even more importantly, if you are in need of a certain amount of capital you can sell only a portion of your holding to raise the necessary amount. Once again, something that's hard to do with real estate. For example, if you have equity in your home, you cannot raise a portion of it by only selling your kitchen.

But here is the point we're trying to convey. The intrinsic value of a publicly traded company cannot possibly vary as much as its market price does. The True Worth™ of a business is a function of its earnings and cash flows. And since operating results are generally reported only quarterly, the earnings line picture of a publicly traded company tends to be a much smoother line than its stock price line. Of course, this is only because the actual variation of this line only changes four times a year instead of potentially hundreds or even thousands of times a day. Therefore, the earnings line is much more calming to look at, if only people did.

Measuring Performance More Comprehensively

We believe that measuring a stock portfolio's performance based on both intrinsic value and price provides a much more intelligent perspective. When an investor can evaluate what a company is fundamentally worth, versus what the market is pricing it at, a much better informed investing decision can be made. When price is significantly above intrinsic value, it is only prudent to consider selling. On the other hand, when price is significantly below intrinsic value, the most prudent behavior would be to buy more.

Unfortunately, since most people focus solely on price, they tend to behave oppositely of how they should. When the price is rising, and even when it rises above fair valuation, greed kicks in and people tend to want to own more of the now expensive stock. In contrast, when the price of a stock falls most people's first inclination is to sell. If fundamentals are collapsing as well, that may be a rational decision. But if fundamentals are remaining strong or even increasing, selling a great business for less than it is worth is a great mistake.

F.A.S.T. Graphs™ were developed so that investors could view a stock based on both important performance measurements. By correlating stock price to intrinsic value, the investor becomes empowered towards making sound or more rational investing decisions. There is nothing that can help investors in making perfect decisions, but more prudent decisions are unequivocally possible. The following graphs look at our eight examples from the perspective of price correlated to intrinsic value.

Our four examples are comprised of four sets of two companies each in similar industries. In each set, we will first show a company with weak fundamentals (earnings) where a stock price drop is justified. The second example will illustrate a company whose fundamentals were strong and improving while stock price was dropping. As was established in part one of this two-part series, the focal time period is 2007 through 2009.

Cardinal Health Inc. (CAH)

Notice how Cardinal Health's (CAH) stock price fell in 2007 as investor sentiment began to turn negative, and how it continued falling as earnings weakened. Therefore, this is an example of stock price volatility equating to high risk, based on deteriorating fundamentals.

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The combination of high valuation in calendar year 2001, coupled with deteriorating fundamentals in fiscal years 2008 and 2009 led to large shareholder losses. As an interesting aside, and our first clue to our secret performance measurement 2.5, notice how Cardinal Health's dividend and payout ratio increased each year.

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Our strong example in the healthcare distributor segment is AmerisourceBergen. Notice the strong correlation between earnings and market price over the long run. Also, notice how stock price fell in 2007 and 2008 even though earnings growth continued to advance at a very high rate.

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When you evaluate the performance of AmerisourceBergen with its strong earnings growth you discover the shareholders were richly rewarded since calendar year 2001. Because earnings held up during the recession, the price drop was temporary and recovered very quickly.

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Package Foods and Meats

ConAgra Foods Inc. (CAG)

Once a very consistent above-average growth company,ConAgra Foods Inc. has found it difficult to maintain a consistent pattern of earnings growth since 2001. Notice that the long-term trend line of their stock price has essentially been flat with a lot of volatility in between. Although stock price and earnings fell in 2008, ConAgra's stock price has recovered with earnings since then.

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Flat earnings produced flat shareholder returns since 2001. When you can view stock prices and earnings together over a long period of time, a clearer picture of what the company offers comes into view.

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McCormick & Co. (MKC)

McCormick & Co.has produced a steady stream of moderate to high earnings growth since calendar year 2001. Prior to the recession of 2008, the market had typically applied a premium valuation to McCormick & Co. giving credit to earnings growth plus a premium for their dividend (light blue shaded area). Although their stock price did succumb to investor panic in the fall of 2008, it has since recovered close to back to its historical normal valuation. The price fell, but earnings and dividends continued their upward trajectory.

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Secret Performance Measurement 2.5 Revealed - A Steady Stream of Dividend Growth

The secret performance measurement 2.5 is the consistent dividend performance of a steady Eddie dividend growth stock regardless of price volatility. For the long-term oriented dividend growth investor, the annual raise in pay provided by the growing dividend income stream is a key performance measurement these types of investors focus on. Regardless of all the price volatility, thanks to growing earnings, McCormick & Co.was able to raise their dividend every year right through the recession. Although long-term capital appreciationwas also strong, it is this increasing dividend (Yield On Cost: YOC) that appeals to the dividend growth investor.

To summarize, these prudent long-term investors invest for the dividend yield the company offers, but even more importantly, for the growth of that yield over time. Therefore, almost by definition, dividend growth investors tend to be long term holders as long as the dividends they covet continue and grow. The inclination to own and hold companies with long legacies of increasing their dividends each year is logically a contributing factor to their low betas. The growing dividend, performance measurement 2.5, is of much greater importance to the dividend growth investor than the bouncing stock price.

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OCharleys Inc. (CHUX)

Here we have a classic example of stock price volatility representing high risk. With earnings in a long-term downtrend, the recession of 2008 only made matters worse. The drop in stock price was clearly justified by the deteriorating fundamentals.

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The most important performance measurement with this company is clearly the constant collapse of earnings. Although there were times when the stock price rose, in the long run its stock price traded down to reflect an annual decline in the company's intrinsic value (earnings).

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Darden Restaurants Inc. (DRI)

A steady above-average rate of earnings growth drove this restaurant chain's stock price steadily higher. The large fall in their stock price in 2008 soon recovered as earnings held up and then growth resumed.

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The shareholders of Darden Restaurants Inc. were well rewarded by the company's consistent operating performance since 2001. Note that the company morphed into a more typical dividend growth stock in 2005 where their dividend and payout ratio were greatly expanded. The secret portfolio measurement 2.5, a consistently increasing dividend income stream has been very steady as their growth yield (yield on cost) grew with their earnings.

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Star Scientific Inc. (CIGX)

This small-cap company, whose primary business is actually making tobacco products safer, represents the quintessential example of stock price volatility. The company has achieved very little in regards to operating performance, but has some very promising prospects in their pipeline that keeps speculators interested. Up to this point, investors (speculators) have relied on a lot of hype and sometimes hysteria. The day may come when this innovative small company may become a steady earnings generator, but it hasn't happened as of yet.

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Although long-term shareholders have been rewarded at an above-average rate, the ride has been as exhilarating as a roller coaster. Therefore, it is doubtful that this company has enjoyed many long-term shareholders outside of its insiders.

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Reynolds American Inc. (RAI)

Our final example illustrates the price-earnings relationship very clearly. The tobacco industry has long been known for its strong profit growth and high dividend yields. However, due to the controversial nature of its product line, there have been stock price declines in spite of continuing good earnings growth.

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Reynolds American Inc. has rewarded shareholders in close approximation to their operating results. Many shareholders have been pleased to own this stock for its high dividend yield. The secret performance measurement 2.5 allowed the dividend growth investor to remain calm through bouts of stock price volatility.
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We believe that stock price volatility represents a performance measurement that is only relevant in the short run. Therefore, if one is inclined to be a day trader, then it is only logical that price performance matters a great deal. However, if you're inclined to be a long-term investor who is not interested in spending hours of each day micro-managing your portfolio, then operating performance (business results) should be of greater concern.

Over the shorter run emotions, primarily fear and greed, will dominate the marketplace. Common sense would indicate that the emotional response is very difficult to quantify or forecast. Irrational and even possibly hysterical behaviors can be quite common when emotions are in a heightened state. Of the two primary emotions, we believe that fear is the most dangerous, but greed can also pose a great threat to fiscal solvency.

Over the longer run, business results will be the primary generators of wealth. The most common metric and the one that our research indicates carries the most weight are earnings results. If you own a company whose earnings are consistently growing, then regardless of what the short-term price movement is doing, your confidence should be high. When you measure price in correlation with earnings, a much more rational overview of your portfolio can be made, in our opinion.

Finally, we would argue that as long as fundamentals remain intact, a falling stock price should be of little concern. Dividend growth investors seem to get this point, they remain comfortable as long as their dividends continue to flow. If the price of your strong company is falling due to negative market sentiments, this should be of no concern unless you were planning to sell that day. However, if you were planning to own the company for the long run (minimum of a business cycle 3 to 5 years), the earnings results the company is achieving should be your greatest concern. The stock price volatility of a great company can only hurt you if you react to it.

Disclaimer: 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.

Source: Proof that Earnings and Dividends Matter More Than Price: Eight Examples (Part 2)