It’s crunch time for retailers as the holiday season gets in full swing. Financial media will be full of headlines about Black Friday and Cyber Monday sales results, and analysts will be focused on data to gauge consumer sentiment. While consumer strength is an important economic indicator, my investment strategy won’t be changing this week — even for my retail stock holdings.
Valuable information vs. distracting noise
Some of the data and news out there is truly pivotal for investment analysis, no matter what your strategy is. However, there’s an overload of information, and the majority of what you can consume is just “noise.”
Noise might seem important, but it doesn’t actually have any bearing on your outcomes. There are tens of thousands of articles published daily about the stock market and the economy. Each stock has thousands of metrics and ratios available for analysis from hundreds of sources. They can’t all possibly be applicable in any meaningful way to every person.
The most successful investors are able to avoid distractions and really hone in on crucial indicators to inform their decisions. First, they need to figure out which data is meaningful and which is merely a distraction.
Two types of valuation
There are many different ways to assess a stock’s value, but they generally fall into two broad categories. Both are equally valid, but they each have totally different sets of relevant information for analysis.
On one side are traders, who make their decisions based on the behavior of market participants. For traders, a stock’s fair price is determined by supply and demand for shares on the open market. That price changes as supply and demand change, so traders need to predict the relative volume of shares offered or requested on the exchanges at different prices. Traders need to understand the momentum driving stocks at a given time. Black Friday and Cyber Monday chatter absolutely influence sentiment around the market.
On the other side are investors. Investors need to think about the fundamentals of the underlying business that’s represented by the stock. Over the long term, a company’s value is determined by its profits. Investors need to determine if a company’s future profits are enough to justify a value that’s higher or lower than the current stock price.
Short-term news for long-term investors
I use the stock market to make long-term investments. I’m not a trader with the skills to analyze technical charts. However, I do have a track record of accurately forecasting business performance and comparing that to a stock’s market valuation.
In theory, shareholders are entitled to the future cash flows generated by the company. Businesses use cash flows to expand and improve operations — if they have more cash than they need, they’ll pay out dividends.
That’s a simplified explanation of intrinsic value. Cash flows are either distributed to shareholders or invested by the company to achieve higher cash flows later (which will eventually be distributed to shareholders). That value is equal to all future cash flows, discounted for risk and the rate of return that would be available elsewhere. A stock’s valuation is therefore very much up for debate, because nobody knows that the future holds. Still, it’s accepted that a stock’s value over the long term will eventually reflect those cash flows.
This is exactly why I won’t be making any big moves based on Black Friday or Cyber Monday results. The profits from any single quarter generally contribute 1% to 2% of the total value that would be calculated via intrinsic valuation methods such as dividend discount or discounted cash flow model (DCF).
I recognize the serious limitations of intrinsic valuation methods, but they are flawed in implementation rather than theory. The next quarter — even the next year — is way less important than all future results, no matter how accurate your forecasts are.
Black Friday is an important snapshot of today’s consumer activity. It’s helpful data for predicting quarterly sales for retail stocks. It tells us a lot about the long-term migration to e-commerce channels. It might even help us predict the next few quarters. All that said, holiday season sales data doesn’t guarantee anything about profits next year. It’s even less relevant for forecasting cash flows two years from now. This quarter’s results tell us next to nothing about cash flows 10 years from now.
I’ll stay up-to-date on economic trends and the overall business climate, but I won’t be buying or selling stocks based on performance this quarter. I own stocks that have economic moats and strong growth prospects. I only sell them once I believe that their business has changed fundamentally or if their valuation seems too expensive for their fundamentals.
This past week’s sales results are distracting noise for me. I need to focus on a company’s overall ability to meet evolving consumer demands and the management’s team capability to navigate challenging environments.
Need Your Help Today. Your $1 can change life.