A Winning Strategy Earnings, interest rates, investor psychology and the stock market
Mario J. Gabelli
From the Print Edition:
Kevin Spacey, Jan/Feb 02
The stock market, as represented by popular indices such as the Dow Jones industrial average or Standard & Poor's 500, can be viewed both as a snapshot and as a motion picture. A recent snapshot has captured equities at their worst. However, Stock Market, the Movie has been a long-running hit, delivering annualized returns from 1926 through the first 10 months of 2001 approximating 11 percent. So, put your digital camera down, pick up your camcorder, and let's start videotaping the interplay of earnings, interest rates and investor psychology on the post-September 11 stock market. But first, let's place equities investing in the proper perspective.
In my opinion, the single best description of prudent equities investing is contained in two short paragraphs from Benjamin Graham's classic The Intelligent Investor, published in 1949: "Let us close this section with something in the nature of a parable. Imagine that you own a small share of a private company that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
"If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position."
It is our, and every prudent investor's job to try to determine the intrinsic value of an individual company or the market as a whole. At any given point, intrinsic value is largely a function of earnings and interest rates. Whether stocks trade at, above or below intrinsic value is a function of investor psychology. Mr. Market is the code name the traditional value investor uses to personify investor psychology.
Graham and his colleague David Dodd, who co-authored Security Analysis, viewed stocks as pieces of businesses to be owned long-term, rather than pieces of paper to trade. Consequently, they saw little merit in assessing intrinsic value based on short-term earnings. Instead, they focused on what they termed "earnings power." Earnings power is determined by reviewing a company's earnings history, evaluating the health of its business and its competitive position within its industry, and then projecting a growth rate for future earnings. Were they alive today, Graham and Dodd would be asking the following questions regarding the earnings power of corporate America in a post September 11 economic environment:
How bad is bad?
How long will the difficulties last?
Are there financial resources available to overcome the challenges?