Sentimentality and Profits

Foreword

You’ll be excused for thinking the stock market is schizophrenic the past few weeks — one moment it is down, the next it is up, and often on the same day!

In an environment like that, how should the rational investor price stocks?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Magical pot of cash

Let’s say you have a magical pot of cash, where every 3 months, an additional $2.50 appears in that pot of cash, and you know this, because the pot is transparent and you can see the money actually in it, and count it.

However, the pot is completely sealed, and there is no way to get at the cash unless you break the pot. Unfortunately, breaking that pot will mean that it no longer generates that additional $2.50 every quarter.

If the pot currently contains $100. How much do you think you can sell this pot of cash for?

Well, if the buyer is rational, they’ll pay at least $99 for it — if nothing else, they can buy the pot for $99, break it and immediately make a $1 profit.

But what if the buyer only has $50? Clearly they won’t be able to pay more than $50 for the pot. And so that’ll be the maximum they’ll be able to bid. Remember, a transaction can only happen when the buyer is willing and able to afford the trade.

Secondly, let’s say the buyer has $150, but anticipates needing that $150 in 2 years. Well, the maximum they would be willing to pay for the pot is $120 — if they pay $120 for the pot, in 2 years, it’ll grow to $120, and they’ll be able to break it to take that $120 out, combined with the $30 in cash they’ll have remaining, they’ll be able to just meet their $150 obligation. Obviously if they want to make a profit, they’ll likely want to spend less than $120 for the pot, but $120 remains the upper bound.

Next, let’s say the buyer, for whatever reasons, feels that starting next quarter, the pot will grow by $5 a quarter instead of the current $2.50. Well, in this case, even if they still only have that $150 and still need that $150 in 2 years, they may be willing to pay up to $140 for the pot — they believe the pot will grow $40 in 2 years, and with the $10 in cash left, they’ll be able to meet their obligations. The buyer may be right, or they may be wrong — maybe they know how the pot actually works, maybe they consulted an Ouija board, or maybe they simply read some anonymous stranger make the claim on Reddit. Either way, that’s their belief, and they are willing to act on it.

Finally, let’s say the buyer has infinite money. In this case, they clearly aren’t worried about liquidity issues, and they may be willing to pay absurd amounts of money for the pot! Even if they pay, say, $1,000 for the pot, they’ll break even in 90 years and anything beyond is pure profit. And they’ll be willing to wait 90 years, because they have no immediate need for the money anyway.

Sentiments

To put it in more general terms, the amount that the buyer is willing to buy your pot for, is based on their personal situation and what they feel the future portends. In a single word, it depends on their sentiments — how and what they feel is going to happen in the future. The fact that the pot generates a stable flow of additional cash is relevant, but orthogonal to how much they are willing and able to pay for the pot.

Stocks

Now, to bring the discussion home — a share is basically just a representation of fractional ownership of a company. If we assume that the company is run by competent managers who are honest (i.e. no fraud), then the company’s business will generate profits over time. The company may or may not pay dividends, and for the sake of simplicity, we’ll assume it does not, in which case, the profits simply accrue on the books of the company forever, either as cash, product inventory, equipment or other assets.

Given that the company does not issue dividends, the average investor has no way to readily access those profits. Like our magic pot, the investor can only watch the profits accrue on the books of the company. However, our investor does have the option of selling their shares.

At the same time, a wealthy enough entity can also buy out the entire company, at which point that entity can then sell the company for its parts and get at the accrued profits, essentially “breaking the pot”.

Profit accrual

The fact that profits accrue on the books of our company is crucial — the company is a productive asset, and so buying and selling shares of that company is not a zero sum game; This is a positive sum game, because the accrued profits are an external injection of “value” into our system.

However, as we’ve discussed before, just because a company is profitable and well run, does not mean that buyers are willing and able to pay up for it. In different periods of time, people may value the same dollar of profit differently.

This may be due to demographics — an economy of retirees may have a shorter time horizon and thus less willing to pay for future profits, while an economy of twenty-year-olds may be more willing to pay more for future profits.

It may be due to political factors — in times of war, physical assets may get destroyed, which may cause losses to the company.

It may be due to irrational reasons — a group of investors who are collectively financially significant may decide to buy up shares of a company for no real reasons other than because “they like the stock”, etc.

In short, the price for each dollar of profit that a buyer is willing to pay (e.g. P/E ratio) changes based on sentiments, mostly orthogonally with the actual performance of the company.

Investing for profit

To profit as an investor, it is thus important to understand that the price paid for each dollar of profit is not a constant, and the market can and do over or under value that dollar of profit at different times. The intelligent investor should understand this, and treat the market as the proverbial irrational neighbor, who comes every day with a different price they are willing to buy or sell the shares our investor is interested in.

As long as the company remains profitable and well run, then the most profits can be made by buying when the market is irrationally valuing its shares at a low price. Similarly, our investor condemns themself to poor future investment returns if they buy the company’s shares at irrationally high prices — the accrual of profits by the company is generally independent on how high the shares for that company trade for.

That’s not to say that you should never buy shares of a company that are clearly overvalued. Just because you cannot make a decent investment return, does not mean that you cannot make a great speculative return! After all, just because you are a fool, does not mean that someone else won’t be a Greater Fool.