Market prices and business performance

Recently, there have been many stock market pundits who have remarked on the fact that even companies releasing stellar earnings reports have been getting punished in the stock market the next day.

Indeed, most investors have probably noticed this phenomenon over the course of their investing careers, in which a company's earnings report will show signs that the business is doing well (and showing the promise of continuing to grow in the future), and yet the stock drops mysteriously immediately following.

We believe this is an excellent way of illustrating the basic truth that the short-term performance of a company's stock in the market is very different from the performance of the underlying business. Intellectually, all investors should understand this, but it is very easy to forget it, given the enormous attention that the stock market and its day-to-day movements generate.

Back in June of last year, we published a post entitled "The airplane and the tetherball" in which we introduced a metaphor that illustrates this principle (and we mentioned other metaphors which convey the same truth, such as Ben Graham's famous "Mr. Market").

In the "airplane and tetherball" metaphor, the airplane represents the underlying asset (such as a business), and the tetherball represents the market price of that asset from one moment to the next.

The tetherball, which is attached by a long bungee-cord, bounces around in all directions, based on the unpredictable and ever-changing air currents that buffet it back and forth. Even if the airplane itself is climbing (the business is growing), the tetherball can be heading downwards for a short time (the market price can be going down).

For example, the overall market may be in a "downdraft" for one reason or another. If the airplane keeps going up year after year, however, that tetherball will almost certainly be higher -- there just may be a delay in the market's recognition, and there will almost certainly be plenty of bounces up and down along the way.

The ability of anyone to predict the next bounce of the tetherball from one day or week to another is suspect, since the "air currents" that can move markets include unexpected geopolitical events, technical market factors, and even the general mood of the day. This is why it makes much more sense to focus on the airplane (the fundamental cash flows and business performance of the underlying asset, in this case a public corporation).

All this is not to say that the market price does not matter -- that would be ridiculous, and investors must perform analysis to determine if even a fast-growing business has become hyped and overvalued. The point to keep in mind is that the relationship between the price and the underlying company is complicated, especially in the short term.

Investors should realize that right now, the market simply "wants to go down." This is a common and normal pattern in the market, particularly after a sustained upward period. In fact, it is healthy for the market to correct and do some "backing and filling."

The prices of good companies -- even companies that release positive earnings reports -- will generally get sucked downward in such a correction. When investors notice this taking place, it should serve as a reminder to them of the distinction between the market and the overall business, and the importance of focusing on the performance of the business.

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