By Jack Forehand (@PracticalQuant)
Valuing companies can be a challenging process. While it is commonly accepted that the value of a company is the present value of its future cash flows, predicting those cash flows and judging their value relative to the current price is an inexact science at best. Value investors like to find companies with higher current earnings relative to their price, which requires less projection of future growth, while growth investors like to look at the future and see the significant growth that companies that successfully execute their growth plans can produce. But either way, valuing a company typically involves looking at its price and judging that price relative to its current and projected future fundamentals.
But what happens when something breaks this process? What happens when companies are no longer valued based on their fundamentals? What happens when factors outside of those specific to each company become dominant over the facts regarding their businesses?
These are the questions many fundamental investors have been wrestling with in recent years. They have puzzled investors who can’t understand why the stock market has lost very little despite the significant economic problems we currently face. They have confused value investors (like myself) who can’t understand why their portfolios continue to underperform even as the fundamentals of their holdings have improved over the last few years (at least before the Coronavirus crisis hit).
Although I personally believe that fundamentals will always matter over the long-term, I think it is important for all of us who have had difficulty understanding what is going on here to take a step back and try to understand what we have missed. This article is my attempt to do that and to look at the factors that have led fundamental-based investing to be far less effective in the past decade.
Have Fundamentals Really Not Mattered?
But before I do that, I first want to challenge my own premise. It is easy for investors who think that something that has occurred in the market doesn’t make sense to look for a place to assign blame. For those of us who follow a fundamentally driven process, it is easy to justify our position that the market is overvalued or that value stocks have done poorly by just throwing out a statement like fundamentals haven’t mattered.
But it is possible that fundamentals have mattered – they just haven’t been the ones we pay attention to. It is possible that stocks like the FAANG stocks that we think trade at unreasonable valuations will grow into those valuations by continuing to deliver growth that exceeds what we think is possible. Going back to the premise that the value of a stock is the present value of its future cash flows, it is possible that future cash flows will end up justifying these valuations. In that case, all the things I talk about in the rest of this article will just end up being justifications for something that could have been explained by traditional fundamental analysis. But I will assume that is not true in order to work through this thought process.
Here are three things that can help explain why fundamentals may not matter as much as they have historically.
The Fed Matters
If there is one lesson all of us can learn from what has occurred this year, it is to never underestimate the power of the Federal Reserve, and governments in general. We have shut down our economy and are at the very least in a severe recession, and yet as I write this, the market is at all time highs. I remember a podcast interview I listened to with Ben Hunt of Epsilon Theory a while before all of this happened where he made the point that it is essentially impossible for a deflationary crisis to derail the market because the Fed will do whatever it takes to save it. You probably couldn’t come up with a stronger test of his theory than what has happened here, and it turns out he was 100% correct.
Here is a chart of the Federal Reserve’s balance sheet from 2007 to today. As you can see, it expanded significantly after the 2008 crises, but that pales in comparison to what has happened in response to the most recent crisis.
Many investors are certainly worried about what all of this stimulus will mean in the longer term, but there is no arguing with the fact that it has made a huge impact in the short-term.
The Fed’s interventions haven’t just had an impact on the market as a whole, though. They also have likely impacted the relative returns of different asset classes, and groups within them. For example, many think the low interest rates are to blame for the underperformance of value relative to growth in the past decade. But whether you believe that or not, it is certainly clear the Fed has impacted markets, and the result has likely been a situation where fundamentals matter less than they traditionally have.
Narrative Matters
We all love stories. They have far more impact on our lives than we can even imagine. They control what we buy. They control who we vote for. They also control our views on the stock market and what we invest in.
John Authers described narrative better than I can in this recent Bloomberg piece. Here is how he explained it:
Markets run on narratives. That is because trading in them is ultimately determined by humans, who find it far easier to think in terms of stories than anything else. Express the case for a stock as a series of numbers and it won’t connect; knit them together into a story and you have a chance of making the sale.
My favorite recent example of the power of narrative is Tesla. The company and its founder have painted a picture of a company that is changing the world in many ways. That story has been far more important to the stock price than anything that has been going on with its fundamentals. And that is what happens in a market driven by stories. The narrative ends up trumping the actual results. Narrative is always important in markets, but it has become more important in recent years, and it has had a major impact on stock prices.
Passive Buying and Fund Flows Matter
Passive investing has greatly increased in popularity in recent years. Most estimates currently put it at about 40% of equity ownership and rising. And it is even more pronounced when you look at it by age group, with the majority of younger investors investing using passive strategies.
When you combine this with the fact that many investors invest in these vehicles via regular contributions to retirement vehicles like 401ks, you end up with a constant flow into market-cap weighted indexes over time.
This can have two significant impacts.
[1] It provides a consistent source of buying and upward pressure on the market as a whole
[2] Since passive indexes are weighted based on market-cap instead of fundamentals, it can drive up the prices of the largest stocks relative to the rest of the market.
And there doesn’t seem to be any reason that these flows into passive funds will stop any time soon. In fact, they probably will continue to accelerate. In theory, if these flows created a mispricing, you would expect active managers to step in and correct it, but given the length of time we have seen these trends continue, it is possible that they won’t or aren’t able to given that they are continuing to represent a smaller portion of the market.
Will Fundamentals Ever Matter Again?
So what are the long-term implications of all of this? Will we ever return to a market driven by fundamentals instead of these other factors? I think the answer is yes, but I also acknowledge that these trends can go on a lot longer than many of us think. I am a big believer in learning from history, and history will tell you that when these periods where fundamentals don’t matter have occurred, they have always eventually reversed themselves. But the trends I discussed above are strong ones, and you can certainly make a good argument that they will all continue for the foreseeable future. In the end, I guess only time will tell, but I think it is important for all of us who invest based on fundamentals to understand the markets do change and to take a detailed look at these trends rather than just discounting them.
Photo: Copyright 123rf.com / flynt
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.
