Investing, a topic for virtually everyone. "Investing" is a term that applies to many walks of life. Examples include: Investing in one's future via gaining a degree or further education, investing in stocks, bonds, mutual funds, or even investing in a potentially life-changing relationship. Essentially, time is the constant in most everything, and this is certainly true with the term "investing". A great (and near and dear) example is the time you have invested to reading this blog post. You came to learn, escape, or achieve a different view on innovation that is not consistent with the norm of thinking. If it's your first go at this blog, welcome, if it isn't, you should love where I am taking this post.
What is fun about this post is the direction I can take it. Because of the vast opportunities in front of me, let me narrow the scope a touch. Let me zoom in on the finance-related view of investing, which touches millions of 401k's, college-savings accounts, and the majority of Main Street America's value, less real estate. Ahh, the stock market.
Traditional investments in equities will tell you that anyone can research a company's financial statements, predict/model future earnings, and thus, arrive at a valuation of stock price. If your valuation is lower than the current stock price, you are propelled to buy. If it's the contrary, you hold a short position; if and only if you hold a margin account with your brokerage firm.
Is there a flaw here? ... that sir/madam would be a resounding YES!!!
But Steven, investing in the stock market has a distinguished history, dating back to 12th century France, how could you possibly find innovation in something so old, established.
That stance is precisely from those that are not thinkers, innovators. Those that don't challenge what is working, has been done, or has been tried in the past. Just because something has been operating for years, if not hundreds of years, doesn't mean it is the most efficient it can be. It doesn't mean there isn't innovation abound. Think about it this way, the human spirit will always prevail, such that no matter how incredible you make a process, market, or company, the next person will be challenged to improve upon the existing being, and will always succeed. That's what makes human existence amazing. We keep growing.
Back to the stock market and investing. Where is the innovation? Simple, it's in the way we value companies and the underlying stock price that dictates the market values of said companies. Far too often, if not always, students of high finance take the equations fed to them in college and apply such academic equations to real-world situations. What's wrong here is equations typically do not factor in experience. Now, before you start showing concern about experience happening over time in one's career, that's not where I am heading. Experience in this instance is a matter of market experience; where the consumer's mindset is via their employer, friends, and competing products/services.
As a result, experience isn't something that requires a 20-year vet of investing in the stock market. In most cases, such experience may hinder response by not being reactive enough to change. Experience here is taking time to adjust to market conditions. I see a circular reference coming up, so let me counter by explaining the following:
Every quarter or year-end, analysts at major firms are surveyed by Factset for the stocks being followed such that the survey responses allow Factset to report the average earnings estimates. If the company comes in below "estimates" the stock tends to drag, and if it's above "estimates" it tends to gain, with respect to other major market announcements such as industry trends, employment data, or other leading indicators.
Innovation? Well, it's in the valuation of companies. I think, we all too often look at future cash flows, complete NPV analyses, and trade via the like. Unfortunately, the NPV doesn't always consider the innovation that may occur within a company. I'm not going to focus on a poster-child example, but I will say, that the equations of future valuation are EXTREMELY flawed.
If the following is an example of predicting valuation (dividend used):
Price = ∑ (Dt / (1 + r)t)
...where D equals the dividend and "r" equals your required rate of return for the period (t).
Given a static dividend, the flaw exists in the "r", the return on capital you expect from the folks running the internal capital investments. Because the "return" fluctuates greatly among stocks you are reviewing, good luck gauging success or failure in your investments. This disparity is definitely true in situations when you don't have visibility into the inner-workings of a company and are reliant on public data.
Plus, and only to complicate the pricing of securities, is that this information is published quarterly, as a result, what could be causing fluctuation in pricing between announcements but market pressures? Haven't you wondered what drives pricing changes between announcements?
Anyway, let's give it a go with this new, never used/finally published equation (you'll love how I leveraged existing findings lest boiling the ocean)
Price = ∑ (Dt / (1 + r)t) * P
This equations gives you a bullish/bearish view of the industry/market. "P" then equals the variable you place on the stock. A variable below "1" gives you a bearish view, and a variable above "1" gives you a bullish view. I recommend not exceeding 0/2, as your outlook shouldn't extend beyond the next quarter of earnings/data release. Also, you should re-assess your factor per competitor's releases post leading-industry players releases. The constant, and consistent valuation of a company will give you an up-to-the-mintue understanding if you are adding value for yourself or someone else.
Valuing P is the challenge then, and this is precisely what I want to do with this post. Unfortunately, I can't provide a table suggesting valuation per industry as timing and markets fluctuate so rapidly, but what I can showcase a framework I recommend to value "P".
When will innovation be seen? (Weighted value - 0.7)
R&D can be a multi-decade process or deliver something with a very short go-to-market strategy. Understand from management what the company is working on and when the benefits will be reflected in the earnings. What you are looking for here is short turnarounds on investments made by the company. If they are going after huge losses that will take years to recover, that will hurt earnings. If they are taking on low hanging fruit or landing large item innovations that are immediately profitable, make sure these are going to be seen in earnings within a year. Beware of management teams that keep talking about innovations but never seem to deliver.
How will the company respond to market changes? (Weighted value - 0.5)
Can senior management give you a vague but directed enough answer to the question "what are you in the business of doing?". If management of an automaker says "we make cars." run for the hills. If management answers the same question with, "we provide transportation options to our customers." then hop on board. The more narrow the focus, the more narrow the mindset/culture of the company, and the less likely the company will quickly shift into new technology or solutions, leaving it open to a swift death.
What will happen tomorrow? (Weighted value - 0.3)
Bring the market into play here. What other earnings are being released? Competitors, like-industries, suppliers, customers, economic data, are all points to consider. Consider this a temperature check on the market place and decide a value that reflects a market confidence level. Market pressures are enough to change a stocks price with or without a company announcement.
Who will be running the show? (Weighted value - 0.2)
Leadership change is just that, change. Some times the market reacts positively, but also negatively. Gauge what you think the response would be and place a value on it.
Where will the company be in one year? (Weighted value - 0.3)
Bring everything together and value the company. Don't just average the above items, but give the number a gut check and stick with it.
Add up your values, multiply this in the Price equation and compare to the current market price. Happy hunting.
-Steven Janke
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