We’re going to dive into the murky depths of the stock market this week. As readers who have been following along for a while now know, this is a subject we haven’t discussed much in these pages.
That’s largely because the financial media puts the stock market at the center of the universe. It’s the Sun around which everything else revolves. It’s the center of modern finance’s heliocentric model.
But from my experience, stocks should make up only one part of a robust asset allocation model. And stock market investments are not the path to financial freedom. They simply help with financial security.
Still, this asset class has a place. As such, we need to look at it with a critical eye.
Here’s the thing – the stock market is a realm of constant evolution. Every epoch has seen its unique set of market trends.
Against this backdrop, the traditional approach to equity analysis hasn’t changed much. And the same approach is parroted throughout the financial media – both official and alternative.
Whether it’s CNBC, Seeking Alpha, or some guy’s YouTube channel, chances are the center of attention is a company’s quarterly earnings report.
Analysts want to know – will the company beat its top-line revenue and earnings per share (EPS) metrics? Or will it provide forward guidance that exceeds Wall Street’s targets?
If the answer is yes, we expect the stock to go up. If the answer is no, we expect it to go down. But have we ever stopped to think about this dynamic?
The fact is, quarterly earnings are just theatre. It’s all just a big game. Wall Street analysts set revenue and EPS targets… and then the market reacts to whether a company hit them. Then we do it all over again in three months.
The EPS metric is often heralded as the crowning jewel of these reports. It’s seen as a litmus test for a company’s health. But is it?
Quarterly earnings reports focus on a company’s short-term performance. That’s baked into the cake. And as we know, short-term results do not reflect a company’s long-term potential.
EPS is a simple metric. It’s just net income divided by outstanding shares. But this simplicity can be deceptive. Stock buybacks, for instance, can inflate the EPS by reducing the denominator (outstanding shares) without any real operational improvements in the company.
In other words, the EPS figure does not give us any useful information to project a stock’s long-term performance.
Yet, companies are acutely aware of the significance investors place on EPS. This sometimes prompts management to “smooth” out the numbers.
This is more common than we might think. And it’s easy to see why. A publicly-traded company’s management team is typically compensated heavily via equity grants.
Thus, management makes more money when their stock price goes up. This creates a very strong temptation to focus on quarterly numbers to the detriment of long-term performance.
That’s why we should never rely on EPS numbers when we are thinking about buying a stock. When all eyes are on earnings and EPS, investors might neglect other crucial financial metrics like free cash flow, debt levels, or return on equity.
Plus, every industry has its own set of unique valuation metrics. We can use them to assess and compare companies across the industry. These metrics aren’t often discussed in earnings reports. But if we don’t do this analysis, we’re flying blind.
Then there’s the media circus to contend with.
Every three months, the financial media fixates upon earnings season. This fixation often leads to stock price volatility. An EPS slightly below expectations can send a stock plummeting… But a marginally higher EPS can trigger a surge.
This volatility can push investors into impulsive decisions. And impulsive decisions are almost always a bad idea when it comes to investing. When we’re not sure what to do, usually the best answer is to do nothing.
So every investor should ask a key question. Do I want to ride this merry-go-round? Am I content to play the short game, reacting to every uptick and downtick?
Or do I wish to invest based on a company’s foundational strength as determined by key industry metrics?
If you’re inclined towards the latter, then our new Cornerstone of an Equity Portfolio report is just the compass you need in this journey.
For starters, this report details a much better approach to equity analysis and risk management. If we’re going to invest in the stock market, we better understand the game we’re playing. The nuances are critical to our success.
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These stocks are the key to long-term success in the markets. And they are the stocks that any serious investor can use to anchor their portfolio.
In the report we also discuss the industry-specific metrics we need to understand and analyze before buying any of these stocks. This is equity analysis de-mystified. Understanding these concepts will make you a better investor going forward.
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