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Fundamental focus

By Adam Baley

A good hunter knows to be in the woods before the sun rises. Last fall, I was up one such morning and making my way to my tree stand. It was dark, and all I had to guide my way was a dim flashlight and memory. A few hundred yards into my trek, I realized nothing looked familiar. I had made a wrong turn in the darkness. I was lost, and I was alone.

I began looking at every tree, hoping one would look familiar and lead my way but none did. I could have panicked, but I decided to sit patiently and wait for the sun to rise. And it soon did, filling the forest with light. It was a lovely morning and, as it turns out, I had missed the path by only twenty yards. 

My, how a little patience and perspective can change the way we see the world!

Don’t miss the forest for the trees

Investors could use a little patience and perspective. I have noticed some investors focusing impatiently on the breaking news – lately, on Europe – grasping at each new story, hoping one might lead the way.

Have patience and put Europe into perspective. Greece won’t sink into the Aegean and Europe will still be a continent. Don’t let the breaking (and often mercurial) news cause you to overlook the fundamentals – corporate earnings and interest rates (and pregnancies). 

As the fourth quarter earnings season advances, corporate America is on pace to post its most profitable year ever. So far, 468 of the companies in the S&P 500 have reported their earnings. Of those, 318 have reported positive growth and 317 have posted a better outcome than expected.

While this is all good news, what’s most impressive is that revenue growth is up 7%, so far. This underscores that businesses are making money, not through cost cutting alone, but through doing business better.

Moreover, businesses are reaching record profits without record leverage. Historically low interest rates have allowed businesses to strengthen their balance sheets – and their profitability – by refinancing and retiring debt down to manageable levels.

Seeing value

And though corporate profits might be at all-time highs, stock prices are not. 

Stock prices, over long periods, move based on corporate earnings. As investors, we must routinely check to see if current prices represent good value. One of the most common measures of relative value is to compare a company’s current share price to its expected future earnings – this is known as the price-to-earnings (P/E) ratio. 

Over the last two years, corporate earnings have marched back, but stock prices have lagged. This has compressed stock multiples (P/E ratios) to a range below historical norms. Over the past year, we have had an environment of record profits, better business models and less leverage. Yet stock prices have remained stubborn. 

Investors’ reluctance to own stocks has created the current disconnect between profits and prices. That is holding down multiples. To paraphrase economist John Maynard Keynes, stock multiples are low because investor “spirits” are low. 

Eventually, the reality of profits and tangible cash dividends should overcome investors’ emotional uncertainty and carry the markets ahead. Ultimately, fundamentals will win. 

Let’s address the other fundamental – pregnancies. Population growth, especially higher rates in the world’s developing economies, creates rising demand for goods and services. As families move to cities and raise aspirations for their children, markets expand, and opportunities for businesses to generate sales increase. A growing population creates a growing customer base for the world’s businesses. More customers means more revenue.

What to expect

Expect 2012 to be marked by continued periods of uncertainty and volatility, but ultimately markets should focus back on corporate profits.

The world has a lot to work through, as we always do. Europe eventually will muddle through its balancing act of austerity and trying to maintain economic growth. The U.S. will have to deal with sluggish job and housing markets and – since it’s an election year – continued political paralysis.

With all the volatility and uncertainty, it is easy to become lost among the trees of bad news. Stay the course, and don’t let your investments be led astray by the daily noise. Good investment decisions are made with prudence and grounded in fundamentals. A little patience and the proper perspective can change the way you see the world. Let corporate profits and demographics shed some light on your investment decisions.

Adam Baley is a registered representative and associate at Landaas & Company.

initially posted Feb. 22, 2012 (updated March 6, 2012)

More Money Talk

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Also on Money Talk
Bob Landaas notes that fundamentals ultimately prevail.
Brian Kilb examines the value of buying when it’s cheap.
Art Rothschild explains the use of price/earnings ratios.

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