For a person standing outside a railway station and trying to understand the patterns of people entering and leaving the railway station – it will seem like people are exhibiting a random behavior. Keen observers will find that there are times when there is a significant traffic and there are periods when there is a lull in traffic. More diligent ones will be able to create complex mathematical models to predict the traffic patterns. These models will never be perfect but will try and explain the “strange” traffic patterns, peaks, lulls, their correlation with the weather or temperature etc.
An alternate way is to try and understand who is using the trains and why, it then becomes clear that traffic is high during school and office hours when people are trying to get to or from school and work places. Trying to take a few additional steps and refusing to treat the reasons for traffic as a black box will help get better insights into the traffic patterns.
The same analogy holds good for markets – when one is trying to understand the movement in stock prices – it seems random for some, others can see patterns. For those who want to take one more step, they will see that this is the price being quoted for partial ownership of businesses. Businesses are valued on the basis of their ability to generate profits (can refer to our article – source of value).
Businesses ability to generate profits changes slowly, some businesses tend to do extremely well and others have indifferent performance or start declining. Interestingly prices of these businesses fluctuate much more than the profitability of the businesses. It seems like prices fluctuations are reflecting sentiments that are easily swayed by extreme fear or extreme greed, and have very little to do with the realities of the business. Warren Buffett says “markets are voting machines in the short run and weighing machines in the long run”.
Let’s look at the earnings of the companies in NIFTY and their prices represented by value of the index. We can see that earnings have fluctuated a bit but have been consistently increasing. Index has also increased over the same period but has had much more volatility.
Even if we consider yearly average to smooth out the daily noise we see that the markets have fluctuated much more than the earnings.
P/E is the number of times its current earnings we are ready to pay to acquire a business, this is one way to value a business. When we plot the fluctuations in the P/E vs the earnings of the companies, we see that our valuation (in terms of P/E multiple we are ready to offer) is very fickle while there is limited volatility in the earnings.
The fluctuations in P/E multiples are high even when we look at yearly averages.
Another paradigm that we can use: Businesses represent goods and services that are produced in the country and hence their market value would correlate with the GDP. When we plot the SENSEX vs GDP we see that this correlation holds good in the long run, but in the short run there are way too many fluctuations in the Index while GDP is tracing a smooth growth path.
We can see that valuation of companies is a fairly difficult art, especially if one is looking to do this over the short term – due to noise (news, opinions etc) which may not have long term impact.
For people who want to take a long term view, once can easily see that the human beings continue to be productive and creative, GDP’s of countries continues to grow, and business continue to thrive and innovate – hence the value of the business (represented by total market capitalization) will continue to increase.
We feel that trying to make short term predictions is a very difficult proposition and fraught with many risks, whereas taking a long term view requires disciple and patience which we believe are far simpler to master.
The question is “this looks easy so why isn’t everybody doing this?”
All of us understand that the “secret of losing weight” is to eat less and work out more, but very few succeed in losing weight in the long run. Similarly – “investing is simple but not easy”, as many find it difficult to have the discipline and patience required to stay the course.