By Rod Blake
Fundamentally, evaluating stocks and markets tends to be pretty predictable and sometimes a tedious endeavour. For the most part, the value of a stock or a market is arrived at by digesting a series of ever evolving numbers to arrive at a value.
We’ve all seen examples of this when analysts publish a report calculating the current value of particular stock or predicting a target price of where it might be a year from now.
It happens four times a year when companies report their quarterly and annual financial reports, or individually when there is a significant change in company fortunes. There are a number of figures and ratios that are used evaluate a stock but a few of the common ones are market capitalization, sales, growth of sales, cash flow, and earnings per share.
For example, the long term average fair value share price of an S&P 500 company is about 15 times annual earnings. So if a company earned $1.00 a share in a year, then its stock price should trade at about $15. This value may vary for different sectors or economic conditions.
By extension, to evaluate the value a large cap index such as the S&P 500, analysts take the reports of all of the companies in the index and then calculate the fair value or future value of the index.
Again, this target level can vary based on the current or futures economic conditions of the day. We’re already seeing predictions of where the S&P 500 will be at year end 2021. After finishing 2020 at about the 3,700 level, I see a number of analysts predicting a 2021 close of about 3,900 for an annual return of about 5% – fairly predictable. But if one considers that the average large cap company grows methodically and pays a relatively small dividend, then a 5% annual increase in price is not too far of a reach.
This is also in line with the average annual growth of the American economy. Fundamental investors use these reports on stocks and markets to see if they are undervalued (a potential buy), fairly valued (a hold), or perhaps overpriced (a potential sale). When I was a broker, if I could consistently give a risk adverse client an annual return of 5% or better, I was more than happy.
Of course, not all investors are wired to invest fundamentally. They may want better than average returns or to be involved with something that is new and dynamic. There is also comfort in numbers. Investors tend to invest in the same sectors that have attracted many others. This is called mass psychology or momentum investing.
You may have noticed the sharp rise in marijuana stocks after the recent U.S. federal election. Investors ignored company fundamentals and rushed into marijuana stocks based on the theory that a Democratic victory would quickly lead to nationwide legalization of cannabis. Just as there are key figures used to fundamentally evaluate as particular stock – there are key indicators that lead to mass psychology investing – things like it’s something new or it’s the next one, a sector suddenly thrust in or out of favour, and the favourite this time it’s different”.
The current Bitcoin phenomenon is a classic example of mass psychology or momentum investing. Momentum investments are great when one is on the right side of the market trend. The downside is that the trend tends to end without warning and can be harsh when the mass psychology changes. And make no mistake – all trends end. There is no such thing as this time it is different. It is never different because the market is always different.
The markets are ever evolving. There is always something new or different coming to the forefront; from the Model T to today’s self-driving cars; from coal to hydrogen fuel cells; from placer mining to heap leaching. Every sector and industry is in a constant state of flux with older or outdated technologies giving way to newer or more innovating ideas. Some trends are short while others much longer.
Many of these trends will take a stock’s price to many times the norm. Technology stocks were trust into favour following last year’s sudden market plunge and have led the market higher. Currently there are many S&P 500 technology stocks trading at or above 40-times earnings – way above the 15-times norm. Some will say that this is the new normal and it may be, and the trend will continue until it doesn’t.
There was a saying that we used when describing a new stock or sector phenomenon – it was “No one knows what it’s not worth”. Over time the market will eventually figure out what a stock is worth. Over time the trend or evaluation will return to the norm. While it is exciting and fun to hold a stock that is rising in value, it is important to realize that the trend will only last so long and it will end when it ends and the masses have moved on.
Junior resource investing also has a fundamental and mass psychology side. Fundamentally, junior resource companies don’t have current sales or earnings but they do have cash and the assets of their orebodies. Analysts will calculate a price for the company’s shares based on the value of the mineral and the potential revenue the company will receive.
Junior resource companies are also very susceptible to mass psychology or momentum investing. This can come about due a discovery or change in mineral prices. The momentum can accelerate exponentially when a discovery of a new orebody results in an Area Play. This typically happens when one company has made a discovery of significance and other companies rush to secure ground in the vicinity.
Investors being primarily optimistic, will bid up the price of all of the companies in the play as they anxiously await assay results to hopefully confirm their insight. The area play can be long-lived and very profitable to investors particularly if there are a number of discoveries in the area such as the current Golden Triangle play of Northern British Columbia. Or they can expire relatively quickly if the initial discovery is the only one confirmed such as the early 1970s Afton discovery near Kamloops, BC.
Of course, the most dramatic example of a junior resource mass psychology phenomenon was the infamous Bre-X Indonesian fraudulent gold discovery in the mid-1990s. Bre-X stock soared from just pennies-a-share to about $290 on consistently good assay reports and optimistic analyst and media coverage only to plummet to zero when the whole thing was exposed as a fraud.
Both fundamental and mass psychology investing are important aspects of the markets and each has its merits and disadvantages. A successful fundamental investor is in a stock for the long haul. For the most part they ignore short term market noise or momentum trends. They focus on the numbers and forgo above average growth for protection of their bottom line.
A successful mass psychology or momentum investor has a much shorter time frame. They tend to put financial reports on the back burner while looking for changes in market sentiment as entry or exit points for a particular stock or sector. They sacrifice downside protection for the chance of a better than average return. If used wisely, both can be a useful arrow in one’s investment quiver.