Why don’t trees grow to the sky? The most common explanation is that trees don’t grow to the sky because of gravity. The taller trees grow, the harder they have to work to overcome gravity to pull water through their roots up to their canopies. The stock market has a similar limitation on growth called fundamentals. Earnings growth, cash flows and profitability are just some of the forces that shape markets. Markets can defy fundamentals in the short-term but over the long-term there is no escaping them.
Over the past year we have witnessed investor sentiment turn from fear to speculation. Understandably so, fear consumed most investors in early 2020 when the pandemic surged and the market plummeted. But it was a brief scare, at least for markets. In fact, it was the shortest bear market in history. One year later, markets are again at all-time highs and we are now witnessing increasing speculation in certain areas of the market. Observe how some investors are getting swept up in buying cryptocurrencies and momentum stocks in hopes of instant riches. This behavior certainly isn’t new and has nothing to do with fundamentals. Anyone remember the tech bubble of 2000? The founder of Vanguard, Jack Boggle said, “the stock market is a giant distraction from the business of investing.” These words seem to apply to the current speculative phenomena. If ever there has been a moment to tune out all this noise, the time is now.
As you recall, we like to invest in companies that are underpriced in the market. Our definition of underpriced includes both absolute and relative concepts compared to the market, their industry group or to their own history. Each month we search the market for stocks that have become statistically cheap on multiple financial measures. Then we conduct our own fundamental analysis of their financials, management and business environment to determine if they are attractive for investment.
This method generally leads us to look at companies when they are not popular. Sometimes an identifiable event creates the low valuation for the company or even an entire industry. In other cases, the cause of the low valuation is less obvious. This is where good, solid fundamental security analysis comes into play. If we can determine the causes of the low valuation and can see they are transitory in nature, we will buy the stock. If the cause of low valuation is not discernable, we will not invest. Thus, we have a dynamic process that regularly produces stocks with excellent return potential. Where this process does not work is with companies that are priced on hope rather than measurable fundamentals.
We provide this reminder to help you understand some of the thinking behind our investment process and give you a sense of the risk and growth potential of the companies in which your portfolio is invested. A little skepticism is a necessary component to sound investment decisions, a principle that has been put aside by speculators in digital tokens and unprofitable companies. While the stock market continues to be short-term oriented and subject to heavy trading runs, the excesses are usually wrung out of the system over time. Better to ignore the fad and focus instead on financially strong, profitable companies with share valuations in line with reasonable long-term growth prospects.
We continue to wish you good health and encourage you to reach out for any support you may need. Thank you for your trust in Cardinal Capital.