What Really Drives Stock Prices?
With all the madness in the stock market over the past couple of years, it can be difficult to figure out which stocks to pick to generate the best returns. After all, investors now have a variety of strategies they can choose ranging from fundamental and technical analysis to ‘Yolo Weekly Options’ and picking meme stocks based on levels of short interest. Each strategy has its own advantages, and the most effective approach depends on your investment time horizon – this is the amount of time you expect to hold an investment and when you would like to realize your eventual gain.
The ‘meme stock’ strategy whereby investors target stocks with high short-interest has performed particularly well recently. For example, GameStop reached an all-time low of $2.57 in April 2020, and less than a year later in January 2021, it rocketed to a record high of $483, for a total gain of 18,700% (turning $1 into $188). For reference, this would have netted you a higher inflation-adjusted return than if you had invested that money for 70 years in the S&P 500 in 1952, which itself has been an outstanding long-term investment.
A fundamental investor might still struggle to explain the 188x increase in the price of GameStop stock by solely looking at their financial statements, whereas a WallStreetBets member who could see the uprising which was happening over the preceding few weeks clearly had an informational edge (a rare thing for a retail investor). Unfortunately, as this was a once-in-a-generation event we must now look forward to how to achieve the best returns in a more conventional market.
Morgan Stanley and BCG conducted a test of all the companies in the S&P 500 between 1990 and 2009 and found that whilst changes in the multiple make up 46% of a stock’s movement over 1Y, it contributes just 5% of returns over a 10Y period with 74% of the return being made up of Sales and Profit Growth. The graphic below provides an interesting visualization of this case study which provides a useful framework for investing decisions:
If you are only investing for 1Y (or less), then a fundamental approach where you try to estimate future revenue growth is clearly unlikely to generate the best returns. Instead, you should focus on which sector or company is likely to have a ‘multiple re-rate’.
A re-rating is when investors expect a stock or industry to have better future performance than previously anticipated and therefore investors are willing to pay a higher multiple (20x Earnings rather than 10x Earnings) and therefore the stock price increases accordingly.
An example of this is the stratospheric valuations for electric car companies such as Tesla or Rivian as investors now anticipate a faster shift to sustainable energy than previously thought. Similarly, other strategies such as technical analysis may yield excellent results over a short period of time in performed correctly although they are unlikely to achieve strong performance over 5-10 Years.
If you are a long-term investor, it is clear from the graphic that your focus should be on which company is going to deliver the best revenue and profit growth over the next 10 years. Whilst the multiple of these companies will change each year, it will eventually balance out and the stock price growth will be equal to any revenue or profit growth there is over the same time. For example, Tesla went public back in 2010 at a price to sales (PS) ratio of 5.29, which declined to a PS ratio of 1.56 in 2019 as investor sentiment waned but then ballooned to a lofty current PS ratio of 18.94. This has clearly been an exception to the study performed by BCG and Morgan Stanley but if the IPO multiple of 5.29 is the normalized sales multiple, then Tesla would have to almost quadruple their current revenue to maintain its current stock price.
It is important when investing to understand what your objectives are and how they relate to the current stocks that you hold. A short-term investor should place the bulk of their focus on industry trends and how this will affect public perception of the companies they own as this is the main driver of stock performance over 1 year.
In contrast, long-term investors must accept that there will be fluctuations each year due to this public perception, but they must remain laser-focused on sales and profit growth whilst ensuring that they have paid a reasonable multiple for the stock that they own. The beauty of investing is that there is no right or wrong way to generate strong returns, but it is essential to understand your own process and the key drivers of your success. Whether it be Warren Buffett with a 50-year time horizon or Jim Simons with a time horizon of just a few hours sometimes, each successful investor has defined their own parameters and operated within them to achieve an incredible amount of success.
Written By: Will Annetts – MSW Contributor
