The 12 Most Important Steps To Understand The Stock Market

by: Valuentum

By Brian Nelson, CFA

After earning my MBA at the University of Chicago Booth School of Business and training hundreds of stock and credit analysts from large organizations over the past 10 years, I have heard just about every question (though I admit I am still surprised by many things and remain a very humble student of the markets). I've also spent years perfecting the discounted cash flow process for large research organizations and studied under one of the most famed aggressive growth investors of all time. So, my knowledge runs the gamut from value through momentum investing. Yet, I continue to be surprised at how easily individual investors are deceived in this day and age. Sometimes I wonder if all of the readily-available (and free) information out there is actually a bad thing.

Hopefully, the 12 steps below, which should be read in order, will help investors understand what the stock market and stock investing is all about.

The Stock Market Is a Market. Let's start with the obvious. The stock market is made up of people. People make mistakes. People have biases. Some people are greedy; some people are fearful. The stock market is not a precise mechanism. If earnings of a company go up 10% in a year, for example, it is almost equally plausible that the same company's stock price may have gone down 10% or up 10% or stayed flat for that same year. Think Apple (NASDAQ:AAPL), most recently. Heck, even if earnings have gone up over a 10-year period, the stock price could still go lower. Think Microsoft (NASDAQ:MSFT) as probably the best example for this one. The stock market is a market filled with individuals making decisions about what to buy or sell. And these buy and sell decisions move the stock price. If there is one experience every investor should have it is to watch a small/micro-cap company's share price move after a large order is filled. Or see a company break out as technical investors pile into the stock. Most sell-side analysts have never seen this; most buy-side analysts have never seen this. And certainly, most individual investors have never seen this. Only through these experiences can the investor tear off the shackles of deception that so many investors want so desperately to believe. We as individuals try to make rational what is not. We try to find complex answers for things even though at times they are so simple. In this case, the stock market is a market. And it doesn't get more simpler than that. Takeaway: The stock market is neither rational nor precise, and it is driven by the buy and sell decisions of participants (including your doctor, lawyer, shoe-shiner, and yes, even your taxi cab driver-or should I say, limo driver).

There is No Long Term. The financial industry loves long-term investors. And rightfully so for them: there is lower flight risk of your assets if you are a long-term investor. It just sounds so good, too: "investing for the long term." And so innocent! Yet, it is one of the market's biggest fallacies. At any point in time, the stock price of a company is based on the expectations of future earnings and cash flow. In 10 years, the stock price of the company will still be based on expectations of future earnings and cash flow at that time. We will never reach the long term. In fact, there is no long term. And please, please understand that this concept is much different than the saying that "in the long-term, we are all dead." What I'm saying here is that stock prices will always be based on current expectations of earnings and cash flow (at any point in time in the future). There is no magic switch 10 years from now that will change the market from a discount mechanism of future earnings and cash flow to a precise mechanism that translates earnings one-to-one from the company to the shareholder. Trust me, it will not happen. If it does, the stock market will no longer be a market (it will be some pass-through entity). Long-term investing is based on analyzing the long-term dynamics of a business and making a stand that at some point other investors will drive the stock toward your intrinsic value estimate (over the long haul). It does not mean that all of a sudden the company will be valued differently because we're now 10 years into the future. Or that the stock price will be higher 10 years from now because earnings have expanded. If you're willing to hold a stock for 10 years, it is very simple: you could have a Microsoft or an Apple (or something in between). The difference is expectations of future earnings of these companies 10 years in the future. Don't fall into the trap of looking at historical earnings and stock price performance and think it will continue. Many gurus that are better at marketing than picking stocks will try to convince you that past performance can be extrapolated in the future through some fancy best-fit regression line. Don't buy it! It simply is not true. If it were, then anyone that knew how to do regression analysis would be a gazillionaire! Takeaway: The core of stock investing will always be based on expectations of future earnings and cash flow at any point in time in the future. There is no long term.

Stocks Do Not Magically Converge to Intrinsic Value or to a Target Price. Often, investors hear that a stock is undervalued or overvalued, and this informs their investment decision as if some magic wand will cause the stock to magically converge to intrinsic value. Stocks can stay overvalued for decades, and stay undervalued for decades, or stay fairly valued for decades. Only when there is buying or selling in the stock based on its undervalued or overvalued state does a stock actually converge to intrinsic value. In other words, it doesn't matter if you think a stock is undervalued or overvalued. It matters if others (after you) think a stock is undervalued or overvalued, and then buy or sell that stock driving it higher or lower--only then will it converge to intrinsic value. The market is not magic - other people have to eventually agree with you for your ideas to work out. As an investor, you are highly dependent on what other people think. You must hope that they eventually come around to what you believe. Or else your stock will never converge to intrinsic value. Don't get me started on Buffett here. The only reason why he wants a stock to decline is so he can buy the WHOLE company on the cheap. For us stock-market investors, we want the stock to eventually go higher. Key takeaway: Stocks do not have to converge to intrinsic value. Only buyers and sellers can drive a stock to intrinsic value.

Everything in the Stock Market Is a Self-Fulfilling Prophecy. I hope you're still with me because this will blow your mind. I cannot tell you how many times I have heard that technical analysis is a self-fulfilling prophecy, and then those same individuals claim that value investing or growth investing is not a self-fulfilling prophecy. Once I hear that, I know that most value investors haven't read Step I above. If you have, you're already smarter than them. Hear me out: technical analysis works sometimes because people buy and sell based on technical analysis, driving a stock higher or lower respectively. Value investing works sometimes because people buy and sell based on value principles, driving a stock higher or lower respectively. Neither technical analysis nor value investing works all of the time. Remember Step II, there is no long term, and stock prices are based on the future expectations of earnings and cash flow at any point in time. Each investor will have a different understanding of what those future expectations are. Stock prices converge to intrinsic value because investors collectively think the stock is worth intrinsic value and vote with their capital to drive the stock price to its intrinsic value. If nobody thought a stock was worth its intrinsic value, it would never reach its intrinsic value. If everybody thought a stock was worth its intrinsic value, it would trade precisely at its intrinsic value. If you think a stock is worth intrinsic value, but nobody else does or ever will then I'm sorry you have an underperformer on your hands. It is this self-fulfilling mechanism that makes the stock market what it is. Takeaway: The stock market is and always will be a self-fulfilling mechanism. If all investors think one thing, it will be true in the stock market.

The Stronger the Competitive Advantage the Lower the Stock Return. This can't be! No way! You refuse to admit it! Everybody can't be wrong! But what about Buffett? Well, you don't have to take my word for it. Ask one of the most well-known shops out there that does Warren Buffett's economic moat analysis. You know what firm I am talking about. Click here (you may need to sign up for a free subscription to view; this data corrects the widely-distributed error found here). All else equal, they concluded that companies with wide economic moats underperform stocks with narrow economic moats, and that stocks with no economic moats had the best returns (over the time period studied). If you're looking for underperformance, it is very likely you will find it by identifying the stock with the strongest competitive advantages. The fact of the matter is that the stocks with the strongest competitive advantages are already discovered - they have already been found. They have already been bid up to levels where excess returns may be difficult to come by. Go back to Step II. Stock prices are driven by expectations of future earnings and cash flow. If investors are buying based on competitive advantage analysis, they are missing the point. Takeaway: Competitive advantage analysis alone will not lead you to the best-performing stocks. It actually has been shown that it will lead you to underperformance.

Earnings Surprises Are Analyst Misses Not the Company's. Okay this is where it gets tricky. The company is not doing better or worse just because an analyst or a group of analysts (consensus) fails to accurately predict quarterly results. Companies beat or miss earnings expectations because analysts are wrong with their forecasts. Nothing against analysts, as it's nearly impossible to accurately predict quarterly earnings all of the time, but this is an important point. Let's ask ourselves these two questions: What if a company continues to miss earnings expectations every quarter into infinity? Will its stock price keep going down forever until it reaches 0? The answer simply is no. Stock prices are determined by expectations of future earnings and cash flow. A company will still have value even if it continues to miss earnings. Consensus estimates and even whisper numbers move around often. And I've even heard of some speculation that some analysts actually raise their target prices and lower earnings estimates (at the same time for the same company), so that specific company can beat estimates (and hopefully traders drive the stock price higher to their target price, so they look smart). This can't be true, right? Well-seasoned market participants may know about this potential conflict and what I am talking about. Still, it is the future that matters. Once a company reports numbers in a quarter, the quarter is over (and is history). The only thing investors care about is the future. Stock prices are determined by expectations of future earnings and cash flow. Takeaway: Earnings beats and misses offer very little value to the investor. Stock prices are determined by future expectations of earnings and cash flow.

The Recent Trend Toward Dividend Investing May Be Good (and Bad) for the Individual Investor. On one hand, individual investors that are interested in dividend-growth investing find strong, stable, dividend-paying companies such as Johnson & Johnson (NYSE:JNJ) or Procter & Gamble (NYSE:PG), and this is great. It prevents them from getting involved in speculative, high-risk companies (remember the dot-com craze), which in many cases is the last thing a retiree is interested in doing. But on the other hand, dividend-paying companies have in many cases been transforming into speculative companies. Many MLPs and mortgage/residential REITs remain overly-dependent on the healthy functioning of capital markets, necessitating global credit health for survival. And many investors are stretching for those 10%+ yielding entities that may not survive for long. Remember SuperValu (NYSE:SVU), Roundy's (NYSE:RNDY), etc. This is not at all a good thing. And while many dividend-growth addicts will fail to admit it, dividends are just a component of cash flow distributed to shareholders, and a company's intrinsic value is based on its entire future free cash flow stream. Plus, a company's stock price is reduced by the amount of its dividend payment (once it goes ex dividend). We won't get into this (as many level-headed authors have tried without success to convince the dividend growth crowd of this). But trust me, it is the truth. Anyone that speaks to the contrary is not doing investors justice. Key takeaway: Dividends are just a component of cash flow, and a company's intrinsic value is based on its entire free cash flow stream.

The P/E Ratio Is a Short-Cut and Used Incorrectly. Unfortunately, many investors are not mathematically-oriented. Remember all of your friends that hated math! Well, the fact of the matter is that the stock market is highly mathematical. It combines math, accounting, finance, psychology, economics, and pretty much every discipline out there. However, many investors don't like the math part and think the P/E ratio is a substitute for actually calculating an intrinsic value or using a research firm that applies intrinsic-value analysis. The fact of the matter is that a P/E ratio is a short-cut discounted cash-flow model. But instead of thinking about the assumptions in a discounted cash-flow model to arrive at an intrinsic value assessment, investors simply assign a P/E multiple to an earnings number. You should be shaking in disbelief right now. Investors don't do this, do they? Yes, they absolutely do. Sometimes they use a company's own historical P/E ratio average or that of comparable companies to assign to a company's earnings. You now know just how wrong this is. A company's P/E ratio should be based on its future free cash flow stream, as the value of a firm is based on the future (not an assessment of its past or a comparable company). Investors won't stop using the P/E ratio because they read this. But you should be aware of the pitfalls of using this metric. Key takeaway: The P/E ratio is a short-cut discounted cash-flow model and investors continue to use the P/E ratio incorrectly.

You Will Be Wrong. Individual investors sometimes think that every idea should work out and immediately at that. Wrong. If you are a good investor, your winners will outperform your losers and you will make money. If you're an excellent investor, you'll still have a lot of losers, but you'll end up beating the market. The fact of the matter is that you will be wrong at times. You will make mistakes. Some of your investments will lose money. I remember one time I received an email from one of our members. He proceeded to tell me that he was so happy that we picked 8 winners, but he was extremely disappointed that 1 of our ideas did not work out. For some reason, he didn't understand that an 8 to 1 ratio is not only good, but unbelievably fantastic! I think it is partly because of this email that I have included 'You Will Be Wrong' in the top 12. Key takeaway: I don't care who you are. You will be wrong at times

Growth is a Component of Value. Unfortunately, the mutual fund industry has confused just about everyone with respect to this concept. There are really not growth stocks and value stocks. There are either undervalued stocks, fairly valued stocks, or overvalued stocks. Growth is a component of value. For example, Google (NASDAQ:GOOG), which is growing fast, can be undervalued, while a company with a single-digit P/E like Apple can be overvalued (at least according to some). Every analyst and investor should build a complete discounted cash flow model at least once in their life to see how growth fits into a value assessment. There is probably no better way to learn this important concept that Buffett has been known to utter a time or two. Key takeaway: There are really not growth stocks and value stocks. There are either undervalued stocks, fairly valued stocks, or overvalued stocks.

Value and Momentum Outperform Everywhere. Momentum is the biggest embarrassment to efficient markets (according to Fama), academic research continues to conclude that 'Value and Momentum' combined outperform in every market across every asset class, and we continue to demonstrate empirical evidence of the superiority of a combined value-momentum process in the portfolio of our Best Ideas Newsletter. Probably one of the biggest mistakes I made when starting our firm Valuentum was that I used the word momentum (at all). Even some of my closest friends dismissed the strategy of Valuentum, saying it wasn't for them, even when I was doing what they were doing with respect to value analysis plus the technical/momentum work. They just never looked at it. They saw that I was using some form of technical and momentum analysis and said "it's just not for me." I understand them. When I was a youngster, I remember reading about how technical and momentum analysis was voodoo and just not worth the time. I get it. People have been conditioned to not like it…fair or not. But by definition, Valuentum investing encapsulates everyone's strategy (from value through momentum). It is not only value, not only growth, not only GARP, and not only momentum. It's Valuentum. It embraces your investment strategy in the vein of Keynes' below. It's my personal mission to spread the work about the combined benefits of this strategy. Investors simply aren't aware of it or are afraid to accept it. Key Takeaway: Value and momentum combined outperform in every market across every asset class.

Keynes Was Right. I remember reading Keynes' work years ago, and it never really resonated with me. But then, let's say, I wised up. After reading just about everything I could get my hands on, spending years and years in school, and training hundreds of analysts in both equity and credit research, I have concluded that Keynes was brilliant. This isn't about his economic policies that you've read about in economic textbooks, but it's about how he thought about the stock market. I have saved this last for a reason. It embodies everything that you have learned above. Keynes compared the stock market to a beauty contest. He said that to pick winning stocks, investors need to pick the contestant (stock) that they think other judges (money managers) like, not the contestant that they like. This is absolutely brilliant, not only because it is true but because he put this into text decades ago! So, the secret to successful stock selection is to have a complete understanding of all investment disciplines in order to find the best stocks at the best time to buy (Valuentum investing). After all, we need deep-pocketed money managers to eventually agree with us for our stock calls to work out. This doesn't mean we're trying to front-run others -- it means we do extensive DCF analysis, an extensive relative value assessment, and a technical momentum assessment to help identify future winners. And just a bonus for all of you Oscar watchers this weekend to really hit this point home. To win an Oscar pool, don't pick the movies (stocks) you want to win - pick what you think Hollywood insiders (money managers) would vote for (buy and drive higher). This is the key to Oscar predicting (successful stock-selection), in my view. Key Takeaway: The best stocks are those that are undervalued and are just starting to exhibit strong momentum qualities, revealing the greatest likelihood of price to fair value convergence.

Disclaimer: The information contained in this article is not represented or warranted to be timely, complete, accurate, or correct. This article is for informational purposes only and should not be considered a solicitation to buy or sell a security. Before acting on any information in this article, you should consider whether the information is suitable for your particular circumstances and, if necessary, seek professional advice. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article. Valuentum is an independent research firm serving individuals, financial advisors, and institutions.

Disclosure: I 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. Some of the companies mentioned in this article may be included in Valuentum's actively-managed portfolios.

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