April 2003 NumberSMART Newsletter

April 2003 - NumberSMART Newsletter©
by Jason Orr

There are two times in a man's life when he should not speculate:
when he can't afford it, and when he can.

-Mark Twain-

Although it may not say so in your job description, your job ultimately is to maximize shareholder value. And we know that shareholders get wealthier in two ways: by receiving dividends and benefiting from an increase in the value of their shares. We also know that there is a correlation between share value and profitability. That is, if Dynamo Corporation is profitable, the market (sooner or later) will recognize this fact and bid up the price of its stock. Why? Because capital always flows to investments with the highest return, relative to risk. That is why stocks have historically earned a higher return for investors than bonds…because they are riskier. The probability of losing money in an equity investment (remember high-tech stocks?) is much greater than the probability of the government defaulting on a bond interest payment.

So if investors want to participate in the growth potential of Dynamo's stock, they will buy it and maybe even be willing to pay a premium for it. With more people chasing a limited resource (the stock), the law of supply and demand (remember Economics 101) dictates that the stock price will rise. The price of Dynamo's stock today represents what investors expect the company will earn in the future; or more precisely, the value of all future cash flow generated by the company. This is how stock prices are determined in a "normal" market. However, we know that at any given time the stock market may be caught in the clutches of euphoric greed or paralyzing fear.

In a "normal" market scenario, Dynamo Corporation is an established company with a demonstrated track record, has a commercially viable product, and is managed by proven managers with real experience. In short, an investor can look at the Annual Report of Dynamo and see what this company has already done. Furthermore, this information can be used as the basis for projecting future profitability, and hence share price. The operative terms here are established, viable and proven.

In a "manic" market scenario, Dynamo Corporation lives in the imagination of its founders. With a business plan scrawled on the back of a napkin (I'm being generous here), the twenty-something whiz-kids who conceived of a revolutionary high-tech idea have successfully sourced their first round of equity financing. Where did the first $20 million come from? From the stock market of course. Ridiculously optimistic growth projections and fawning stock analysts have helped fuel a buying frenzy for its stock. Financial gurus, stockbrokers, investment pundits, and maybe even your co-workers are all lauding the merits of this wonderful investment opportunity. The market has become enthusiastic beyond reason and collectively taken leave of its senses. And Alan Greenspan famously coins it "irrational exuberance" In short, the stock market bubble has continued to expand at an ever-increasing rate and you might feel like the party has started without you. But what has really happened here? Is anyone out there thinking rationally?

Let's go back and ask our dot.com whiz-kids a few questions. Is their company established and does it have a proven track record? No. Is there a demonstrable demand for their product? No. Are they proven managers with real experience? No. And herein lies the problem. Nothing in this scenario is proven or verifiable. And yet we poured trillions of dollars into a myriad of Dynamo's in one shape or form. For many of us a lifetime of savings disappeared into a vacuum. Why? Because we forgot some basic principles of investing.

These principles are relatively easy to understand, but exceedingly difficult to live by. The fact is: investing has nothing to do with intelligence, luck or ability; it has everything to do with disposition, character, and temperament. There are really only a handful of things you have to remember. But you must adhere to them religiously, as if your life depended on it.