04 Sep 2015 Ignore Opinions, It’s Earnings That Matter

Investing in stocks is the very best way to passively build wealth over a lifetime. But too many think it is more like gambling than sensible wealth-creation. The stock market’s gyrations of late can certainly reinforce the argument that it’s too risky a bet for the family nest egg.

Unfortunately, the average investor is poorly educated, or ‘mis-educated’ on the fundamentals of stocks, their markets, and what they represent. Too often investors are not educated or counseled. More often, they are sold products that play to their current emotions of fear or greed.

So quickly, here’s a simple explanation of stocks. At their core, common stocks represent ownership of the imaginative, innovative, and productive potential of every human employed by a public company in the world. Put another way, stocks entitle their owners a share of current and future earnings that are generated by every company he or she owns. If it is an exceptionally broad basket of stocks, such as the VTI and VEU that we hold, he essentially owns a majority of the commercially-engaged human ingenuity on the planet.

So when markets decline 10%, 20%, or 40%, what is the takeaway? Do people believe that 10% or  even 40% of companies are going broke? Do they believe that humans and the companies they represent have forgotten how to make profits? No, the answer has far more to do with emotions than logic. Ben Graham, the father of fundamental investing, said the market is a voting machine in the short run and a weighing machine in the long run.

What he means is that in the short run uncertainty rules the day and markets can swing wildly up or down on emotion until rational confidence returns. It is easier for companies to grow and generate better earnings when economies are strong. Predicting how companies will do when the outlook for the economy is cloudy is almost impossible, creating a gap in confidence that can pull markets down substantially.

At some point after a steep decline in stock prices, investors begin taking a longer, more rational view of companies’ value relative to their ability to continue growing their earnings in the future. The ‘weight’ of evidence through modern, even ancient history suggests that smart managers, innovative researchers, and productive employees will eventually prevail to generate higher earnings than before, making their depressed stocks a better bargain than they were before ‘votes’ were cast in the latest ‘correction-election.’

Historically speaking, stocks have always come back after market corrections to test new heights. Viewed up close, emotions have more to do with the daily results than most anyone associated with the industry wants to admit. For the past 12 months the ‘voting’ has centered around the Fed and when they will raise interest rates. As a results, stocks as measured by the Total US Stock Market have been up and down, but mostly sideways.

But as we back away and look at the last five years we see a more organized picture of stock growth which is based on the ‘weight’ of solid corporate earnings growth. Total US Stocks are up 14.9% per year over this period.

We can choose to worry about what the Fed is going to do, how China and Europe’s economy will impact ours, what the elections mean for stock prices

OR

We can understand that stock prices are inextricably tied to corporate earnings and be assured that until the desires for human beings to out-create, out-produce, and out-maneuver their competitors ceases to exist, stocks will continue to rise in value, building wealth for those who patiently hold them.