In a year that has seen 40 percent swings in both directions, it’s hard not to be utterly transfixed by the stock market’s performance and many of the stocks that have been carrying it this year. Like any year in the market, it’s the investment performance of some stocks that seem to dominate the headlines – and why not? That’s where the action is. That’s what drives emotions and draws people in, like some sort of animal magnetism.
Why Investment Performance is a Costly Distraction
But, when you think about it, investment performance is nothing more than an output. It’s a result of what goes into a business to generate its growth. The question that tends to get lost in the fog of short-term investment performance is whether that growth is sustainable and whether it can be compounded over time to generate reliable long-term investment returns. That can only be determined as a result of a company’s business performance, which is what actually propels the business.
Since a company’s investment performance is a product of its business performance, it can’t be a reliable indicator of future performance. It’s a company’s business performance that is a more reliable predictor of future stock performance. But, with stock prices flailing around, human nature leads investors to focus on the shiny object that’s moving around and anchor themselves to stock prices instead of what’s actually going on in the business.
Business Performance as a Reliable Predictor of Investment Performance
A stock may be a high-flyer now, but what happens when the landscape changes? If the company’s business fundamentals are adversely impacted by changing market or economic conditions, its stock performance will suffer. For example, before COVID and the economic shutdown, airline stocks were enjoying their best gains in years. However, while their profits were improving due to operational changes, they were still taking on enormous amounts of debt – which is necessary if airlines want to expand their fleet. When the crisis hit, forcing airlines to ground most of their fleets, that debt caught up with them.
But, it didn’t take an economic crisis to know that the business performance of airline companies was on shaky ground. Any company that relies on debt to finance its operations will always be susceptible to market or economic shocks. So, in reality, the pre-COVID investment performance of airline stocks didn’t reflect the companies’ underlying business performance, which was fueled largely by debt. Companies with low or no debt and solid business performance are better positioned to navigate market or economic shocks.
The Right Company Can Perform Well on any Track
From an investor’s perspective, we can’t know how the landscape will change, so we should focus on companies that can grow regardless of the landscape. I like to use my son’s X-Box racing games as an analogy. When you start a race, you first have to choose a car. There’s a big selection, which always makes me wonder which car is the best. What I came to realize after losing countless matches with my son is that it depends entirely on the racetrack. He knew which cars perform best on different racetracks. I was just picking cars based on their looks with no consideration for the type of racetrack.
The point is, as investors, we don’t get to pick a company’s racetrack. Even if we could, we can’t know if it’s the right one because we can’t know what the future will bring in terms of market or economic conditions. Our best bet then is to pick a company that performs well on any track. For example, a company with no debt and sound business performance characteristics is likely to perform well and even thrive, while others suffer due to rising interest rates or inflation.
It’s during periods of extreme volatility and stock price consolidation that investors need to dig deep and form conviction in their investments. That can only happen when you really understand what you own. You will appreciate that conviction if the business continues to perform as expected, and its stock ultimately advances to new highs. That’s why we focus almost all our energy on a company’s business performance and refuse to become distracted by momentary fluctuations of its stock price. We know that, if the business continues to perform as well as it is expected to do, the investment results will follow.