If I told you that during the past 20 years Cincinnati-Ohio based grocer Kroger (NYSE:KR) grew per share earnings by 8.6% annually and the share price grew by 8.9% per year, I don't think that would surprise anyone. Earnings-per-share increased by about 420% over that two-decade period, and the share price has marched right along - increasing 450%. We know, at least on a theoretical level, that over the long-term share price performance tends to track business performance. And Kroger is a prime example.
Yet I'd like to explore an interesting side note to investor psychology. It's my view that investors in general tend to overestimate the business result / share price performance relationship in the short-term and perhaps underestimate it in the long-term.
Let's work with an example to get a better feel for what I mean. I'm going to present you with 10 random periods of earnings-per-share performance for Kroger:
Now what I want you to do is guess which periods saw the best share price performance and which ones saw the worst performance. More than that, I want you to think about the magnitude of each period. Think of it as a time machine. You don't know the length of the periods, or the order (remember its random), but these are actual changes that occurred.
Think about it in another way. Let's say I came to you and said that I could tell you the future with Kroger. I don't know what the share price is going to do, but I know with precision what's going to happen to per share earnings. Is that something that you would be interested in? I'd think it would be.
Well in the above table here you have it, a time machine of sorts, now it's time make your wagers.
If I had to guess, without the introduction and this article's title prompting you, I'd contend that a good deal of investors would select the first and second periods as the "worst" and "best" moments to be invested respectively. The reality is nearly the opposite. And the rest of the results may surprise you:
Time for a confession: I said that the above periods were random, but that wasn't true. You see I'm lazy with this stuff, so I just broke the 20 periods down into 10 two-year timeframes and presented them in order. What's interesting is that even arbitrarily dividing the changes in earnings-per-share and share price gives a good lesson in investor psychology.
If you add up (or I suppose multiply up) all of these changes you get to the 8.6% and 8.9% respective annual growth rates that I mentioned above. Yet what happened in the interim, over all these two-year periods, was much more compelling to watch.
For starters, you had the run-up in the tech bubble. And it should be noted that we're working with fiscal years here, so "2000" means end of January 2001 and so forth. Kroger was actually making less during the boom, but shares were almost indiscriminately going up and up. Thereafter the business started to rebound, but the recession weighed heavy.
From 1996 through 2007 the earnings-per-share and share price of Kroger grew at a very similar rate (around 7% per annum). Yet as you can see, what happened in the interim varied greatly. Indeed, in seven of the 11 one-year periods the share price zigged when earnings zagged. That is, earnings were up and the share price declined, or earnings were down but the share price increased roughly two-thirds of the time.
Expressed differently, that time machine that I was talking about - be it good for one or two-year periods - wouldn't have done you much good. Indeed, it could have actually been harmful if you bet that share price must follow earnings in the short-term. In the long-term things generally work out - Kroger ended both fiscal year 1996 and fiscal year 2007 trading around 15 times earnings. So overall price growth very closely matched business results. Yet during the short-term there's no mechanism that requires this to be so.
More recently we've seen the same thing. An exception is 2008 to 2010, where shares remained trading around 12 times earnings and the profits of the company slightly declined. Here you have a strong relationship. Otherwise, things have been much "too hot" or "too cold" from a share price perspective.
Actually that may not be fair: we know that share prices are going to ebb and flow a whole lot more than business results. Still, the differences can be telling.
From 2006 to 2008 earnings increased 25%, and yet shares declined 12%. In turn, the earnings multiple went from 17 or so down to 12. As just mentioned this stayed for a while (through 2010), but eventually started to become a coiled spring.
From 2010 to 2012 per share earnings increased 50% and the share price increased by 29% - a rather solid gain - but not enough to keep up with earnings. As such, the earnings multiple further declined from 12 down to 10.5 or so. The stage was set for outsized performance.
By this point earnings had grown by a compound rate of 7.6% since 1996, while the share price had only grown by 5.4% per year. And given a reasonable starting valuation, you now had that "coiled spring" of solid increasing earnings with a much lower earnings multiple.
The business results were impressive from 2012 through 2014 - increasing 33%. Yet here's where the share price really took off - increasing nearly 150% in just two years. In 2014 alone earnings were 20% higher and yet the share price jumped 90%.
You can make up all sorts of reasons, but I'd go back to the investor psychology described above. For years you had share price performance trailing business performance. So the earnings multiple kept getting lower and lower. And eventually enough people woke up and said, "Whoa, Kroger is still growing at a nice clip but is only trade at 10 times earnings." This sentiment was quickly realized in the way of a materially higher share price: the earnings multiple jumped from around 10.5 all the way up near 20.
Indeed, this could have been a bit "too far, too fast." This fiscal year (2016, but ends in January 2017) earnings are expected to top out around $2.10 - $2.15 or so. So that means that earnings would be up about 20% in the last two years - still quite impressive. Yet the share price is actually down 5% or thereabouts during this time. The valuation has drifted down towards 15 or 16 times earnings.
That's a rollercoaster ride. And if you're not prepared for it the investing world can be a tough place to stomach. Yet if you recognize that there will be natural ebbs and flows, and embrace rather than fight them, this is when things start to get fun.
I could have told you the exact earnings performance of Kroger over the last 20 years, and still many would get the short-term outcome wrong. Over the long-term your guess might have been nearly on the money. Yet in the short-term, and were still talking years here, you could be off by great orders of magnitude.
As it shares stand today, with a "reasonable" valuation near 15 times earnings, you might expect share price performance to more or less track business performance over the long-term. I believe that's a fair presumption. It doesn't mean it's right, but it's fair. The important part to remember is that this doesn't happen in a nice linear fashion. Instead, you can see frequent bouts of share price performance greatly trailing or cruising past the more stable results provided by the business. Keep this in mind, and you'll be well ahead in the investor psychology department.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.