Can You Answer This Stock Price Quiz?

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Includes: JNJ, MCD, MMM, SPY, WFC
by: Eli Inkrot

Summary

In general terms we know that investment performance tracks business performance over time.

However it’s important to point out that the long-term and short-term can differ dramatically in this arena.

This article provides three stock price quizzes to better illustrate the idea.

Recently Tim McAleenan Jr. had a great post over on his website about the finicky nature of stock prices. The idea was that business performance and short-term stock performance don't always match up. Over the long-term prices generally reflect the success (or failure) of business, but in the interim there's no set course that pricing bids must follow. As such, you can get unusual results as emotions and expectations regularly bounce about.

In his example Tim used 3M (NYSE:MMM), but it follows that any number of securities work as a longstanding illustration. I'll show you what I mean.

I'll start with a quiz. Below have I presented the last four years of dividend and earnings-per-share growth for a well-known company:

Which year appears to be the best? That is, which year would have you assumed offered the best share price performance? And the worst? Without polling the reading audience prior to publication I'd contend that 2012 or 2013 appear to be the "best" years based on those metrics and 2014 and 2015 appear to the "worst."

Here's what actually occurred:

The security I'm referencing is McDonald's (NYSE:MCD). The company saw solid income growth from 2011 to 2012 and a bit of EPS growth, yet the share price declined from $100 down to $88. Alternatively, the company reported lower earnings in 2015 to go along with a seemingly lackluster dividend growth rate, yet shares jumped from $94 to $118 - a 26% climb.

Naturally the underlying reasoning is that investors had different expectations at different times, but that's the point. People spend all of this time of trying to figure out what will happen next month, next quarter, next year. Yet even if you predict the business perfectly you have no mechanism available to you that requires the share price to react as you believe it should.

From the end of 2011 through 2013 the dividend increased by 23% and EPS by 5%. Alternatively, from 2013 through 2015 the dividend increased by "just" 10% and EPS actually declined 10%. If you owned the whole business, the first period looks better than the second. And if I had told you these results to start, I'd contend that a good portion of investors would have preferred the first period.

Yet the first period saw a share price that went from $100 to $97, as compared to $97 jumping up to $118 in the second period. The fickleness of share prices should be striking. Not in an "I'm scared to invest because short-term prices don't make sense" sort of way. Instead its along these lines: "no need to panic (or get overjoyed), I know short-term prices don't always reflect long-term prospects." It's simply something that you should keep in mind. Things generally work out, but it doesn't have to be on your timetable.

Let's try another one:

Here I have omitted both the actual year and the security's name to make the point even clearer. If you're just looking at the dividend and EPS growth, you see the model of consistency. (By the way, the other business metrics are quite consistent as well.) Picking out a "best" and "worst" year isn't perfectly straightforward, but that's sort of the point.

If I asked you order the years from "best" to "worst" in terms of share price appreciation (or depreciation) you'd have about as much luck as trying to guess the combination of your nearest padlock. Moreover, as we saw above, having the information that the business or income was "better" in one year or another certainly does not have to translate to a "better" share price movement either.

Here's what actually occurred with the share price during the years noted above:

The security is Johnson & Johnson (NYSE:JNJ) and the timeframe was the end of 2007 through 2015. The "best" year in terms of dividend and EPS growth turned out to be the worst share price performance. Granted this was at the beginning of the great recession, but this should nonetheless be instructive. Johnson & Johnson the business was humming along nicely, it was investor expectations and general short-term concerns that drove the bids lower.

And who would have picked the sixth year (2013) as the best? If you knew the actual date beforehand it might have come to you in hindsight, but that's very different than getting it right in the moment. The dividend growth and EPS growth wasn't drastically different than some other years, yet the share price climbed 31% that year. After spending five years in the $60's (and $50's) Johnson & Johnson's share price quickly shot up to the $70's and $90's.

Here's the most interesting part to me: during this eight-year stretch both earnings-per-share and the share price increased by a bit over 5% annually. You would have started and ended with an earnings multiple of just over 16, resulting in share price movement that roughly tracked the business performance. Over the long-term an improving business generally sees this reflected in a higher share price.

Yet as we can see from above this was far from a constant process. Although earnings and dividends marched upward year-after-year you had three years where Johnson & Johnson's share price actually declined. Think about that from an owner's prospective: the business is doing better, making more money and paying you more, yet others are now willing to pay less for your ownership claim.

It's like if I had an outstanding bid on your rental property, when you come along and say that you were able to negotiate a 10% higher rent and I reply: "that's great, now my offer is 90% of what it was." It happens all the time in the investment world. A lower share price, especially in the short-term, is not a sure sign of a less valuable investment. It's just that your liquidity to sell today (if you're so inclined) has decreased.

And naturally this works the other way as well. Johnson & Johnson wasn't a 30% better business at the end of 2013 as compared to the beginning. It's just that for a few years prior to that the business improvements were not being accounted for. As such, you had a few years of stagnation before a tremendous increase all at once.

Let's look at one more:

Once more I'd contend that it would be especially difficult to pick out which year was the "best" and which one was the "worst" by simply looking at business performance. And certainly the arbitrary year-end timeframe can add to the uncertainty. Naturally the large decrease in earnings followed by dividend slash appears to fairly bad news. On the other hand, the increases in the later periods appear to be quite compelling.

Here's what actually happened to the share price:

The security being displayed is Wells Fargo (NYSE:WFC) and the timeline is once again 2007 through 2015. There was a recent excerpt in Money Magazine detailing that while the S&P 500 index (NYSEARCA:SPY) declined 37% in 2008 the total return of Wells Fargo was actually positive. Which is factual: shares started at $30, ended at $29.50 and once you add in dividends it was a positive return. Yet it's quite misleading in the same way that this table picks arbitrary marks.

There was great volatility during that time (70% swings) so an annual look doesn't exactly paint the picture as it was. Still, we can learn from this illustration.

There's no perfect sign as to when or why a certain set of pricing bids must occur. From 2010 to 2011 Wells Fargo increased its dividend and grew earnings-per-share from $2.20 to $2.80 - leaping over its pre-recession mark. Yet the share price went from $31 to $27.50.

Had you owned the entire business surely you would have been satisfied with the improvement. By being a part owner your subject to an additional level of psychology whereby the business performs well but other investors are now willing to pay less.

Or how about picking out the 6th year as the "best," in share price terms, of the bunch. Aside from the context of the year, there really isn't sure fire way to say that that particular period was obviously better than the one that proceeded it and "only" showed 24% appreciation.

Once again, the long-term versus short-term provides an interesting narrative. Looking at the eight-year period, both earnings-per-share and the share price of Wells Fargo increased by a bit over 7% annually. You started and ended with an earnings multiple around 13, resulting in the share price tracking the business. Yet in the short-term, we saw exceptional ups and downs.

It's easy to be a long-term owner when you're thinking in the long-term. It becomes a bit more difficult when you're bombarded with much lower bids in the interim.

In short, over the long-term share prices generally reflect the operating performance of businesses. There are exceptions of course: a high or low starting or ending multiple can drastically alter a security's investment performance. Yet when considering reasonable start and end-points - think Wells Fargo starting and ending at 13 times earnings or Johnson & Johnson beginning and ending with the same 16 P/E - the share price will track the business performance (for good or bad).

A lot of people take this as a sign that this is always true. This can be a grave error. As we have seen above, short-term bids can vary drastically from the business results. Even if I gave you the exact business performance this does not allow for a foolproof way of figuring out the short-term stock price.

If I told you that Johnson & Johnson would earn 8% more and pay you 8% more in the next year that might be welcome news. But there's nothing preventing the share price from fluctuating 20% up or down. Once you parse these two items out - short-term versus long-term share price movements with regard to business performance - the psychology of the investing world becomes a whole lot easier.

Disclosure: I am/we are long JNJ, WFC, MCD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.