We're Buying Stocks, Not Companies

For the holiday season, we are republishing some of our most popular pieces of the year.

Right after our launch we shared several notes that explained some of the most important principles of our strategy.

The FIRST one we published was this one. We are buying stocks, NOT companies.

This is difficult for most investors to understand but perhaps the most important single aspect of trading and investing to master.

Here is that note…

At HX Research, we have some essential concepts that we have developed over our three decades of investing—these "guiding principles" of our investment strategy.

In the last five years, we have shared many of those with our readers; today, we share one of these. Enjoy!

Watch the financial news media and listen to the "smart" money. You will hear them talking about the "fundamentals" all the time.

What does “fundamentals” mean?

In finance terms, it means the underlying financial metrics and news around a company: how much it is earning, the state of the balance sheet, the valuation of the company's stock, etc.

Almost all market pundits accept that the fundamentals are the most important thing to understand with a stock.

Well – the “smart” money is dead wrong.

The vast majority of the time fundamentals really don’t matter for stock prices.

This likely flies in the face of everything investors are taught, but it's reality.

It's essential to understand the difference between a company and a stock. In the real world, an investor would buy a company. For instance, you might buy a gas station. Now that you own the gas station, you can access the cash flow that the business generates and do whatever you want with it. You could keep the cash in the bank… transfer it to your bank account… or use it to invest more in the business.

The owner, though, owns these cash flows… and they have real value.

On the other hand, stocks represent public equity ownership in a company… But when it comes down to it, they're just pieces of paper. When you buy a stock, you don't contractually have access to the business's cash flow.

A publicly traded company can choose to pay out cash flows as dividends. It can also use cash flows to buy back stock and reduce the total number of shares outstanding. Or it can use these cash flows to pay out management and make good or bad investments.

While company boards and management have a fiduciary duty and a legal obligation to protect investors, these are seldom really put into play.

I used to tell my analysts that the value of a company and a stock only converged in two scenarios. If Company A buys Company B, Company B is worth what Company A was willing to pay for it. Or if it goes bankrupt, it’s worth nothing.

The rest of the time, the value of the stock is simply a matter of opinion. Dividends and buybacks may influence this opinion, but the stock is worth whatever the next buyer is willing to pay.

This is one of the biggest disconnects – and frustrations – that “smart” investors have with stocks. They determine a value for the underlying company and its cash flows and then expect the stock price to (eventually) match up with that analysis.

The reality, however, is that this is seldom the case. Instead, the analogy I often used with my analysts is to think of stocks as art pieces.

Fundamentally, these items don’t have any economic value, yet buyers may pay exorbitant amounts of money to buy them. They can also go up and down in price quite a bit.

So then, what are the drivers of their “value” and these price movements?

The primary driver is simply supply and demand. If more people want to buy than sell, then the asset's price has to increase until the sellers are willing to sell it.

Investors’ “opinions” of many factors determine this demand – including the artwork's scarcity and "quality." Potential future demand for the piece of art also sets these expectations.

Note that all of these factors are impossible to prove.

The same can be said of the factors used when investors set their opinions on the value of stocks. They may have views on a company’s future revenue growth, cash flows, or merger and acquisition potential, but these can be difficult to prove.

They don't matter in many ways because the stockholders will not see any of these cash flows anyway.

The reason the stocks go up is when more buyers than sellers have an increasingly positive view of these factors and therefore, are willing to pay more. They are opinions, not facts.

Does this mean that no relationship exists between fundamentals and stock prices?

Not at all. In addition to the binary outcomes we mentioned (buyout or bankruptcy), for the most part, market opinions closely align with the development of fundamentals. But this is because investors choose for this to be the case. It’s not being forced by any specific equation.

This is perhaps the most crucial concept in stock investing. It’s also the most frustrating one for many investors to understand.

The accepted view is that valuation and fundamentals drive share prices. Still, they are just factors that can drive opinions about the underlying companies. Since they’re only opinions, you can see stocks "de-couple" tremendously from these factors

Suppose an investor thinks that stocks should closely reflect the value and value creation of the underlying companies. In that case, this doesn't make sense to him.

The most important thing for a stock investor to do is have a firm grasp of the factors driving the opinions of the buyers and sellers of an individual stock. These may be the factors of valuation and cash flow. Still, sometimes, they could be something completely unrelated.

Keep this in mind when buying stocks (since we aren’t actually purchasing the companies), and you can avoid a lot of frustration.

At HX Research, we focus on the stock and making you money!