The future is not what it used to be - or is it?

Anyone with a passing interest in capital markets will have noticed that the markets are down in 2022. More down than others are tech stocks and, with them, the tech-heavy Nasdaq 100. The common wisdom is that tech stocks trade at very high multiples (they are very expensive relative to the money they make now) because investors expect the dramatic growth to continue for a long time. Share prices are falling since the world’s economies have hit various speed bumps, and people are worried that at least some countries are facing a recession (i.e. the economy is getting smaller). That is why they do not want to pay as much for those high-growth stocks. It makes sense, right?

There are a lot of moving parts in there. From a fundamental analysis perspective (where you try to find out what a company is worth), the price of a share should ideally reflect all the money a company is making in perpetuity (i.e. forever). If you know what those cash flows (money that a company is earning) are, a quick crisis should not change your view of what the company and its shares are worth.

It is impossible to know what the future will bring, but it is reasonable to expect that it will include some ups and downs. Over time, a company will turn into an average company growing more or less with the market, which should grow in line with the population (more or less). Think about it: no company can grow faster than the market forever; otherwise, it would become the market, right? In the past, we have seen that even the growth of the most dominant players slowed, and their margins (i.e. the amount of money they make) stayed flat. Some companies, e.g. Coca-Cola, manage to keep their margins higher for a long time, but they are the exception rather than the rule.

So if the share price reflects the fair value (the actual value of a company) throughout the life of a company, our expectations of what the future looks like must have changed dramatically. Do investors suddenly worry that there will be more or more significant crises in the next hundred years? The company’s products will be obsolete (no longer needed) in twenty years? Or will people not want to pay as much for the products by 2050? In short, is the future different from what it was just a few months ago? That is unlikely and begs the question: how would investors know? And what made them change their expectation of something that they could not understand in the first place?

There are various reasons why a share price can fall beyond a change in the long-run expectations. First, investors value the next couple of years more than the distant future. If they think that the here and now is tricky, they will expect “their” company to do less well and pay less for it. High-growth companies are vulnerable at their early stages and less resilient to economic crises. Their shares are now riskier, and investors tend to demand a discount for risk (they expect to pay less for something risky). The price will go down.

Phew, that was dry. Let’s try an example: Let’s say you have ten coins and you sit in a crowded dimly-lit place. Someone, let’s call him Dodgy Dave, comes to you and offers a coin toss game. If you win, you get 40 coins; if you lose, Dave gets your ten coins. Sounds great, right? Dave will not let you look at the coin; as we said, the light in the room is not very bright. You look at the coin again, and somehow, it now looks like a dice. Someone at your table may even say, “hey, that’s a dice!” making you even less certain. That would be a significant change. You have one out of two chances of winning with a coin toss. You now think the game is a dice, so you would have one out of six chances of winning (because a dice has six different sides)! What will you do? Of course, you will ask Dave to give you at least 60 coins (10x6) if you win. Dave will tell you that he only has 40 coins to give you if you win. You will say, fine, then I will only put up five coins to play. Everybody agrees that it is a dice, and Dodgy Dave will have to accept five coins instead of 10. The price of the gamble has come down.

That is what happens with a share price. Investors still believe that the company can “win” (the right number comes up on the dice), but the path to winning is less clear. They see a lot more that can go wrong, i.e., many other numbers can come up on the dice. They also hoped the light would be a bit brighter, so it would be easier to see. Your decision to put five coins instead of 10 is a discount, like the share price of a racy company falling from USD 100 to USD 50.

We can take investor psychology one step further. You may have ten coins, but you have seen a hole in your shoe, and you will need some of the money to fix it. You will then only offer to put one coin to play. If many other people in the room feel like you, Dodgy Dave will have to bring down the price for the gamble. In the real world, if people are worried that they may not have enough money to pay for their day-to-day expenses, they will not buy shares, and the price will come down.

So when you hear the “talking heads” (the people who comment on the market on TV or the internet) explaining that share prices have come down because long-term expectations have worsened, think of Dodgy Dave and his coin/dice. People still look at the same device but see a dice instead of a coin. The game appears riskier than they thought.

The future is still as unknowable as it has ever been. Anyone who claims to base their investment on clear ideas of what the future is like, is almost certainly going to be wrong. Flying cars in the year 2000, anyone? Who forecasts the iPhone? What changes is that investors are becoming more aware that there are more ways that their expectations could not come true. That it is a dice, not a coin.