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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Index of Economic Freedom Released; U.S. slips

The annual Index of Economic Freedom, published as a joint effort by the Heritage Foundation and the Wall Street Journal, has recently been released for 2010.

The Index is a valuable tool and one which investors should pay close attention to. We have previously explained our longstanding framework for measuring the climate for investing in any given country or region using the "four pillars" of tax rates, interest rates, level of monetary stability or inflation, and level of freedom. The Index is one of the best resources for evaluating the varying levels of freedom on a global basis.

It is also valuable for evaluating the changing levels of freedom in different countries, and the direction they are heading (either towards becoming more free or less free).

In that previous blog post on the "four pillars," as well as in other previous posts such as "Return of the 1970s, part 2," we noted that there have been some disturbing trends towards lower scores in the U.S. in all four of those important categories, and the latest Index of Economic Freedom bears that out. The United States is one of the most declined countries in the Index this year, declining in seven out of ten categories measured in the study, and falling to eighth in the world from sixth a year ago.

As you can see from the map pictured above, America now ranks behind neighbor Canada, which ranked seventh last year.

How should investors react to this information? We have written on this topic in the past. We would recommend reviewing the thoughts found in the following previous posts:

• "Panning for gold during unfriendly business climates" 09/30/2009.

• "Return of the 1970s, part 2" 02/17/2009.

• "Return of the 1970s?" 08/11/2008.

• "The Unstoppable Wave" 01/12/2009.
  

• "The Unstoppable Wave: Revisited" 12/22/2009.

• "Does a rising tide really lift all boats?" 07/20/2010.

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Paying yourself first, revisited

Nearly a year ago, on March 26 of 2009, we published a post entitled "Paying Yourself First," in which we reiterated the importance of establishing a systematic mechanism for adding capital into savings on a regular basis.

Market corrections make systematic investments all the more powerful. For instance, since the date of that blog post, the broad market represented by the companies in the S&P 500 index has increased in price by over 34%.

We noted in that post our experience that "this is an area in which investors -- even very wealthy investors -- often have good intentions but haphazard execution."

In light of this fact, we believe it is important to remind investors of the importance of this practice of regularly watering their crops, so to speak.

The market correction that is taking place right now (which take place regularly and which are a necessary function of markets) is an excellent time to remember this point. However, we would also point out that investors should not wait for corrections, at least not with all of their contribution. It is important to have a regular amount which goes into investments using dollar-cost-averaging, although holding back a portion (50% or less) of the monthly or quarterly contribution to add during pullbacks is a strategy that we endorse.

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What a farmers' market can teach us about money management

In his 2008 book In Defense of Food, author Michael Pollan explains some of the benefits to obtaining food from a farmers' market, and he does so in terms that strike a chord with us as professional money managers.

Beginning on page 159, he writes: "If you're concerned about chemicals in your produce, you can simply ask a farmer at the market how he or she deals with pests and fertility and begin the sort of conversation between producers and consumers that, in the end, is the best guarantee of quality in your food. So many of the problems of the industrial food chain stem from its length and complexity. A wall of ignorance intervenes between consumers and producers, and that wall fosters a certain carelessness on both sides. Farmers can lose sight of the fact that they're growing food for actual eaters rather than for middlemen, and consumers can easily forget that growing good food takes care and hard work. In a long food chain, the story and identity of the food (Who grew it? Where and when was it grown?) disappear into the undifferentiated stream of commodities, so that the only information communicated between consumers and producers is a price. [. . .] So here's a subclause to the get-out-of-the-supermarket rule: Shake the hand that feeds you."

That paragraph should be read and re-read carefully by investors, because we have long been strongly convinced that the arguments it is making are absolutely true for the financial services industry. The "industrialization" of the money management business has created a "long food chain" between money managers and consumers of money management, such that very few investors today are able to actually "shake the hand that feeds them."

The "farmer" who far away is cultivating the soil of their portfolio and planting it with individual securities is removed from the investor by the long and complex apparatus of the financial industry, with its enormous "supermarkets" selling a lot of their equivalent of processed food-like products.

There is abundant evidence that the industrialization of money management is making a lot of investors "sick" (judging from the studies of long-term returns across the broad range of investors). There is also evidence that what Mr. Pollan describes above as a "wall of ignorance" between producers and consumers has grown up over the past decades, and that this situation indeed "fosters a certain carelessness on both sides." We would argue that the implosion of many of the financially-engineered products created by Wall Street in 2008-2009 is incontrovertible evidence of this fact.

We have presented many of these points before, backed up with extensive data, such as in our series of articles on what we call "The Intermediary Trap."

As more and more of what Mr. Pollan calls "actual eaters" discover drawbacks to the "length and complexity" of the "industrial food chain," we would advise "actual investors" to use it as a lesson that they can apply to their search for healthy money management as well.

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Was the decade lost?

We recently published "The Investment Climate: January 2010" in the commentary section of our website.

In it, we summarize the current situation and provide some perspective on where we stand today.

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