The Emotional Versus Financial Cost of Investing in Stocks

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Over the past couple months, worsening macro economic conditions, declining corporate profitability and a bottomless stock market have investors longing for the good old days when increases in GDP, declining unemployment, and higher corporate profits and sales resulted in a rising market. When times are good, the emotional cost to putting money into the stock market is very low. Who does not remember how easy and fun it was to make money in the late 1990’s, when the market only seemed to go up? Conversely, today’s emotional cost to investing is very high with investors and market commentators viewing any suggestions to invest as an indication that they are speaking to someone that needs to be institutionalized.

Sadly, while the emotional cost to invest is very low when times are good, the financial cost can be very high. Ironically, when the emotional cost to invest is at its highest, investors are likely staring at attractive opportunities. Using The Applied Finance Group’s Value Expectation model, we evaluated the sales growth expectations priced into stocks in March 2000 and October 2008 to highlight the emotional and financial costs tradeoff driving investment decisions.

March 2000 – LAISSEZ LES BON TEMPS ROULET

By March 2000, unemployment had fallen 4 consecutive years, to reach a historic low of 4.0%. Similarly, GDP growth from 1996 to 2000 consistently exceeded 3.5%, flirting with 5% during a couple of those years. By March 2000, the S&P had almost tripled in 5 years.

During this time period, corporate America made investing easy. Sales growth for the S&P 500 Industrial firms increased from 6% annually in 1996 to 13% annually in 2000, while 2000 EBITDA margin levels achieved a record high of approximately 18%. That environment created a reassuring backdrop for institutions and individuals to buy, and in the process ultimately drove stock prices to unsustainable levels. Using The Applied Finance Group’s Value Expectations model, we determined that in March of 2000 the S&P 500 Industrials required 22% annual sales growth for the next 5 years to justify its market value, compared to its 9% average sales growth from 1992 to 2000. In other words, these firms had to more than double their average growth rate for five years or investors would suffer negative returns. While the March 2000 economic environment was very inviting to investors at the time, it was a financial disaster for investors. Since then, the S&P 500 is down 45%.

October 2008 – Is That Blood On The Street

If March 2000 represented Heaven for investors, then October 2008 will likely be remembered as Hell. GDP growth has ground to a halt and turned negative, recession fears are everywhere, financial companies have been failing or forced to merge, credit markets are frozen, and the market sold off nearly 40%. Investors are now coming to grips with what will likely be a horrible economic/corporate climate for the near term, combined with increasing government regulation, resulting in a very high emotional cost to “pull the trigger” and make investments today. While the emotional cost is much higher today than in March 2000, investors are being offered significant financial incentives to buy stocks.

Unlike 2000, when the market demanded record sales growth to justify its current levels, today’s markets have priced in significant future sales declines. Today’s stock prices reflect that the S&P 500 Industrial firms will experience 6% annual sales declines over the next five years versus the 22% sales growth embedded in their March 2000 prices. In other words, the market is pricing companies today to lose over 15% of their existing sales over the next five years. While possible, such long-term pessimistic expectations create a lucrative opportunity for investors.

Winners and Losers History and Prospects: March 2000 Vs October 2008

Since March 2000, the S&P 500 has generated –5% a year price returns. This is not surprising, as the expectations investors built into security prices at that time were extreme. Applying AFG’s Value Expectations process to individual companies reveals how important it is to understand the expectations embedded in a security’s price. For example, in March 2000, only 33 companies in our sample had negative sales expectations built into their price. Though the S&P 500 subsequently suffered large losses subsequent to March 2000, the firms with such low expectations bucked the trend and actually generated positive 50% returns over the next three years. Companies with such low expectations in 2000 included names such as: AZO, MO, HPQ (then it was HPC), and MAT.

Today many world-class franchises are available at expectations reflecting a very bearish future. Over 150 companies in the S&P 500 (industrials) have negative sales growth expectations embedded into their current market valuations. These companies include high quality companies such as: COH, CSCO, DOW, CAH, TGT, JNJ, UTX, SBUX, and WAG, among others

Conclusion

In today’s market investors are understandably very uncomfortable to commit capital. The macro environment is depressing, corporate news is generally negative, looming political changes seem unfriendly to investors, and the market has been declining since October 2007. This makes investors generally hesitant to “get back on the horse”. While the emotional environment is very poor for investing, the financial environment has become much more attractive. Investors who are willing to take an intermediate perspective on the market and invest now and/or cost average over the next few months (for those who are concerned with the short term direction of the market) in stocks with low performance expectations are likely to be rewarded very nicely in the years ahead.

 To download the  list of companies that meet the criteria Click Here