What really drives sharemarket returns?

Market pricing often has little to do with what a company is worth. Photo: Paul JonesHave you ever wondered what drives sharemarket returns? I mean really drives them?

We all know the usual answers – though they vary, depending on your school of thought. Those who use charts as modern-day sheep entrails will suggest that past prices give you a guide as to what future prices will be. Rational economists will say ‘It’s the profits, stupid’, while behavioural economists say share prices will be ‘whatever the market wants them to be’. Stockbrokers paid to ‘know’ these things will have an unshakeable faith in their ‘twelve month price targets’.

So many possible answers. So much conviction. So much error.

Well, that’s not completely fair. In fact, depending on the time period and the company, they could all be right! Thanks for nothing, huh? Separating the wheat from the chaff

Not so fast. Let’s break down the investing experience. First let’s work backwards. How should the fair price of a share be calculated?

Well, in the special jargon that only economists and analysts can come up with, the ‘fair value’ of a company is the ‘total value of its future cashflows, discounted to the present’, or similar.

In other words, if you paid $10 to buy a company (a cheap company, to be sure), then a ‘fair’ price is one that pays you back that $10, plus rewards you additionally for the risk of buying it in the first place.

You could put your $10 in the bank and earn, say, 2.5 per cent, so if you buy a business – which is riskier than cash in the bank – you want to earn something more than 2.5 per cent. Otherwise you should have left the cash in a term deposit and gone fishing.

With me so far? Good. Now to the real world

That’s the theoretical fair value of a company. But, as I’m sure you’ve noticed from the manic nature of the market, share price swings – on a daily basis – don’t seem to be a measured and thoughtful result of such a calculation.

That’s because, with a nod to the behavioural economists, on a daily basis, the market owes more to the moods and predilections of those who buy and sell. During the dot老域名出售 days at the turn of the century, investors (though that term is generous in this context) were prepared to pay what were, frankly, stupid prices for companies that were even tangentially related to the technology sector. That’s why the second tranche of Telstra’s privatisation was at a price we haven’t seen for many, many years – common sense was abandoned as the ‘gold rush’ took over.

It’s important to note that the ‘fair price’ doesn’t change just because the market’s mood does – but the ‘market price’ does.

I hope you’re starting to see an opportunity. The spoils go to the rational

The father of value investing, Ben Graham, famously said that in the short run, the market is a voting machine, but in the long run, it’s a weighing machine. Whatever forces of fear or greed that are impacting the market on a given day allow the thoughtful long-term investor to take advantage.

If I offer to buy your $10 note for $15, you’d take me up on the offer. And if I was selling a $10 note for $5, I hope you’d jump at the chance – and beg me to sell you some more.

Now, we all know a $10 note is actually worth $10, right? And you wouldn’t willingly buy it for $11 or sell it for $9 – but that’s what investors do, all the time.

Both Woolies and BHP were selling for $38 per share not long ago. Now Woolies is under $23, and BHP is a touch over $17. Now, knowing those numbers doesn’t tell you which is correct – but it shows clearly that when a company’s shares can be so volatile in such a short time, the market doesn’t know either!

What about the chartists? Well, they can tell you where a share price has been – but that’s not useful. They can also tell you where they share price might go. That’s not particularly useful, either. So, unless you can find a chartist with a long-term, market-beating track record (and with a methodology that can be successfully replicated), you might be best to give it a very wide berth.

Ditto the stockbrokers – knowing a ‘price target’ is akin to knowing someone’s weight loss goal. Sure, it’s nice to know what they’d like to have happen – but whether it’ll happen is an altogether different proposition – especially when you consider the market moodiness that I mentioned earlier!

So where are we to go from here? The simple (and right) answer is back to Ben Graham. That name may not be familiar, but you’ll almost certainly know his best student: a young Midwestern American by the name of Warren Buffett. Foolish takeaway

No-one can reliably tell you where share prices will go in the short-to-medium term. And despite what you’ll hear elsewhere, that’s anywhere up to three years. The first 36 months after any investment is made is likely to be characterised by those two opposing, yet destructive forces – fear and greed.

The spoils go to the investor who can remain rational, while being aware of his or her behavioural biases. And to the investor who takes advantages of the market’s irrationality when it’s presented – which is most of the time.

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Scott Phillips is a Motley Fool investment advisor. You can follow Scott on Twitter @TMFScottP . The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).

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