How Mr Market Influences a Stock Price
by Greg Canavan
Editor, Sound Money. Sound Investments

A company's stock price is determined by two factors - earnings and emotion. The earnings part of the equation is what investors should focus on. Earnings (relative to invested capital) drive a company's intrinsic value.

For most companies, changes in earnings and intrinsic value occur very slowly - much more slowly than suggested by the daily fluctuations of stock prices.

Investor emotion accounts for these fluctuations. Many years ago, Benjamin Graham characterised this emotion as 'Mr Market'. Sometimes Mr Market was very happy and positive about the future and was willing to pay handsomely to buy shares. At other times, Mr Market thought the sky was falling in and wanted to give those same shares away at bargain prices.

Mr Market's whims can have a far more important effect on a company's share price than its actual earnings. So it pays to be aware when Mr Market is strutting around town offering high prices for shares, or when he is panicking about a company's future prospects. Our aim is to take advantage of his moods.

This is how Mr Market works. Say a company is trading on a price-to-earnings (PE) multiple of 10 times (which is the same as a 10% earnings yield). Let's also assume that the share price is $10 and that this represents intrinsic value. In a rare example, investors have priced this company rationally.

Then, the central bank decides the economy needs a boost, so they cut interest rates and unleash a flood of money into the financial system. Due to past indiscretions, the banking system is not too healthy and the real economy's appetite for more debt is not so great. So instead of making new loans with the freshly created central bank money, the funds flow into asset markets. Stock markets are a prime beneficiary.

Not realising (or ignoring) the fact that the new funds are policy induced, and not the result of sustainable economic recovery, Mr Market gets all excited and starts bidding up the price of shares. In a period of 12 months, our company goes from a PE multiple of 10 to 20 times, pushing the earnings yield down to 5%. Because the economy is stagnant, earnings do not rise. But Mr Market thinks they will eventually so his optimism has caused a doubling in the share price, to $20.

The following year sees a little less government and central bank stimulus because of a slightly improving economy. Our company manages to produce a healthy 20% rise in earnings. For the sake of simplicity, lets say that the earnings increase has also produced a 20% rise in intrinsic value to $12.

Unfortunately, the earnings increase is a little less than Mr Market was expecting. Suddenly, he begins to doubt his judgement. "What if things go wrong? What if fiscal and monetary stimulus really does nothing more than create the illusion of prosperity? The news out of China is not good - their economy is slowing more than I thought it would. What am I doing in stocks, get me outta here. Who wants to buy some shares?!"

Mr Market is beginning to lose it. He is no longer prepared to put a premium on stock prices. Instead, over the course of 12 months, the earnings multiple on our company shrinks to 8 times (a 12.5% earnings yield). The share price plummets from $20 to $9.60, well below intrinsic value.

In this hypothetical example, our company's stock price has fluctuated wildly despite earnings increasing by 20%. This actually happened to many quality Australian companies during 2008/09. Earnings for the 2009 financial year showed modest increases on 2008 numbers, but the influence of Mr Market suggested anything but.

Making fun of Mr Market's apparent stupidity is easy in hindsight. But as investors, we are Mr Market too. Taking advantage of his mood swings can be incredibly difficult because the same emotions that are flowing through the market are the ones you are experiencing.

So it's best to treat Mr Market with respect, not contempt. Understand his influence without coming under his spell and you will a much better investor. You will learn to ignore the day to day noise and will not be pushed into making a stupid decision based on what everyone else is doing.

Here's another way to think about how emotion can help or hinder you. When the outlook was good, Mr Market priced stocks at 20 times earnings. Buying stocks at these levels is the same way as saying you are happy to accept a 5% earnings yield. No one in their right mind would accept a 5% return on a risky asset like equities, so the 5% now comes with the expectation of a higher yield later. Strong future earnings growth (the reason for the optimism in the first place) is meant to take care of that.

But it rarely does, which is why paying too much for a stock almost never pays off. This is why we set our discount rate (another way of saying earnings yield) at a base rate of 12%. Discounting a company's expected earnings by 12% ensures there is a reasonable risk/reward trade off. Knowing the value of a company based on a sensible discount rate helps to take the effect of emotion - the fear and greed we experience daily - out of our hands.

This is an especially important consideration as 2010 gets underway. There is a lot of cheerleading in the financial services industry about how governments or central banks won't let deflation happen or won't let economies fall into recession.

We would caution that artificial tinkering with the market only influences the short term. Long term healing and sustained economic growth can only be generated by the private sector - by profit maximising individuals. Greater government involvement in an economy will lower long term productivity. Mr Market will come to this conclusion slowly, and the price he is willing to pay for companies will decline. So make sure you're not paying too high a price now.

Editor's Note: Greg Canavan is editor of "Sound Money. Sound Investments", a financial letter providing wealth generation and protection opportunities in a post credit bubble-bust world. For more information, email info@soundmoneysoundinvestments.com.au