A company’s share price reflects our collective assessment of its future. Investors, investment advisors and financial analysts spend a great deal of time brooding over the books of publicly listed companies. They go with a magnifying glass over financial statements to find out how well a business is run and how it compares to its competitors.
Profit margins, total debt, production and labour costs, turnover and the line-up of new products are measured, as well as management, customer satisfaction, workers’ rights, pricing power and attitudes towards shareholders, to name a few.
By doing so they arrive at an estimate of future earnings. The stock price should reflect these future income streams and represent their discounted value.
Of course a lot of things can go wrong along the way. To put a price on the future is a risky undertaking. But as with weather forecasts, one can get it right most of the time, while being spectacularly wrong a few times. This is what “value” investors do.
A prominent example was Bill Browder, an early and very successful investor in Russian companies in the 1990s, who noticed that shares were so cheap that even if managers “stole 90 per cent of production”, which many did, these companies would still be highly profitable. And they were costing mere fractions of their capital assets. If one just closed them down and sold their machinery, one would still make a profit.
Investors are not soulless calculators though. Often they react exuberantly when new technologies are developed, preferring hope over bean counting. Many lose their nerves when markets suddenly crash. Emotions triumph over calculus.
Even when we think little of this, we still have to respect its effects. Markets can overreact, and it will impact on us. We might even ourselves react to what we expect others to do – a phenomenon described as “reflexivity” by George Soros, the legendary investor.
Sentiment and mood both influence stock markets but are hard to measure. They can be predicted to a certain degree by ‘chartists’ though, stock market analysts who observe the patterns of rising and falling stock prices like fever curves to offer their forebodings. This looks like irrational witchcraft, but it has sometimes surprisingly predictive accuracy. It is like hearing a hidden message in radio interferences.
I think the reason for this calm is that the market is stunned. There is no insurance against the kind of damage done to the US and the world at large
Certain market occurrences will evade the predictive accuracy of both value and sentiment investors. To ameliorate the effects of the financial crisis the world’s central banks have over many years pumped enormous liquidity into financial markets, buying governmental and corporate bonds, mortgages and even stocks at unprecedented quantities.
When a buyer with a bottomless wallet signals her willingness to do “whatever it takes”, prices will no longer reflect sober analysis or the emotions of other market participants. The assessment of the future of a company must then be replaced by an estimate of the future behaviour of central banks.
Legal consequences too are difficult to predict. It is well-nigh impossible to foresee whether a company has manipulated markets or defrauded customers, that it will be investigated for corruption or the flaunting of environmental laws. And there is also no way to evaluate the possible size of criminal fines and the cost of ensuing class actions once the malpractice is known. Volkswagen springs to mind, banks manipulating markets, Siemens, or lately Petrofac, the oil engineering company which is under corruption investigation. Its share price more than halved in the last few weeks. Will it be the once-in-a-lifetime buying opportunity, a crippling damage or complete doom?
Natural and man-made catastrophes will always rank among the “known unknowns”. Bad harvests, earthquakes, war, a cyber-attack. Statistics will help, if only to a certain extent. Yet the most unexpected risks, the ‘unknown unknowns’, spring from political vicissitude. The genius investor Browder hopelessly mischarged the possible consequences of his success. When his investment assets had multiplied to the equivalent of $4 billion, he was kicked out of Russia under dubious pretences, legally defrauded of his investment house and saw his brave, local lawyer Sergey Magnitsky tortured to death in prison.
Other political risks spring to mind. How will UK companies fare once it becomes clear what Brexit really means? How could Germany’s electricity companies have possibly predicted ‘Energiewende’, with politicians forcing them to close down perfectly profitable nuclear power stations?
The highest political risks in absence of war are caused by ‘regime change’, provoked by forces within or outside the political structure of a country. Think of the Arab ‘Spring’, the Ukraine, Venezuela, or Turkey. While such events clearly wreak unfathomable damage, they are still local phenomena. They can be mitigated by spreading country risk or leaving a market with a black eye altogether.
But what no one can hedge against is the radical uncertainty radiating from the current US administration. In the tweet of a second, one pillar after the other of the international order, created and vouched for by the US for more than 70 years, is collapsing. War with North Korea, Iran or China is all of a sudden not unthinkable any more, as is the World Trade Organisation, the UN even, without the US. Things will happen nobody can yet conceive. Yet no matter how outrageous every new twist and every new tweet, the markets stay calm as never before. This can mean a few things: we agents in the markets perhaps believe that Trump never means what he says and never knows what he talks about. That he will learn. That he will U-turn. That he will soon be history. That people around him will have a calming influence. That his party has good reforms in mind. All this of course is the triumph of hope over reality.
I think the reason for this calm is that the market is stunned. There is no insurance against the kind of damage done to the US and the world at large. There is no workable strategy, no possible mitigation to be contemplated with a calm mind. When scenarios become so outlandish and their consequences so much out of proportion, they become uninsurable.
There is “no hedge against the assassination of Archduke Franz Ferdinand,” as one hedge fund manager put it. As nothing can be done we may as well stay calm and carry on. Such is the calm before the storm.
Andreas Weitzer is an independent journalist based in Malta. He reports on the economy, politics and finance. The purpose of his column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice or advice on the buying and selling of financial products.
Please send in any suggestions for discussion in this column to: editor@timesofmalta.com – Subject: Sunday Times Personal Finance.