So I am sitting in a random Starbucks as usual wondering off my mind here and there, while squeezing in some studying time on my upcoming exam.
I haven't checked the CBOE volatility index (definition here), but we are in some pretty wacky environment with S&P hitting new lows since 1997. There are a number of experts predicting the S&P could go down to 600 or 400, and on top of that the negative feedback loop is going full speed across consumer and business spending sectors (I have to admit I am one of the herd that asked my family to delay the upgrade of a newer, shiner, and much bigger LCD TV as opposed to the 27" 15 years old tube TV that currently sits in the living room).
I don't know how low the market will go, but I would like to share some of the lecture materials in my CFA studying that hopefully can provide you with some encouraging information about our doomed financial market. Stock prices has been known as one of the leading economic indicators, and the earning power of the underlying firms plays an important role in determining which direction the stock prices might go.
To estimate earning power, there are three different methods suggested by the lecture:
- Estimate net profit margins based on recent trends
- Estimate net profit before tax margin
- Estimate operating profit margin, which is defined as the earnings before interest, taxes depreciation, and amortization (EBITDA) margin percentage
The book argued that estimating EBITDA is the best method because this measure is before interest, taxes, depreciation, and amortization, so it will provide more stable estimates of net profits than the other two methods.
Taking it word for word, we also examine the factors that may affect EBITDA estimates
- Capacity utilization - There is a positive relationship between profit margin and capacity utilization. As production increases, there should be a decrease in per-unit fixed costs because costs are spread over a greater number of goods
- Unit labor costs - There is a negative relationship between unit labor costs and operating profit margins because labor costs are the major variable costs of a firm.
- Rate of inflation - There are three possible effects that an increase in inflation can have on profit margins, they are either positive, negative, or indifferent. Usually it's a negative relationship because firm faces elastic demand for its products and will not be able to fully pass on the inflation to its customers
In addition, these relationship are also influenced by the business cycle. Immediately following a recession, capacity utilization will be low and utilization will increase sharply as the economy recovers. Labor will also not be bargaining for pay increases at this time so there will be small increases or even decreases in unit labor costs. Thus, profit margins increase greatly in the initial stages of a recovery.
Every recession is different, and the one we currently face is on a global scale for the first time. The drop has been deep and severe with no recovery visible in sight. However, we are currently two years into the financial crisis, and one has to wonder how much more can the overall market decline in the next two to five years. We are close to a point where prudent businesses face favorable factors to increase their bottom line, yet they are currently traded like their junked competitors (Berkshire Hathaway comes to mind).
"If you like it at $50, you will like it at $40, if you like it at $40, you will love it at $20", the people who try to sell you technical trading platforms/strategies usually say it sarcastically. The price argument is very misleading from a technical or fundamental buy and hold approach. The current stock price is just a scorecard that the market assigns. It is the underlying business that only matters.
Just because I paid something for $50, it should not influence my future decision on the price I am willing to pay. Examine the business as you were the owner, and I am sure you will be more comfortable with the recent plunge. If the business's prospect has deteriorated, and it was doing well in the last couple years only because of leverage and/or credit boom, realize our mistakes and get rid of its shares. The probability of poor business to recover is much lower than a better business. It will be a painful lesson, but mistakes provide us with valuable lessons and aid us to become better investors.
(All materials are from 2008
Kaplan Schweser CFA level III Books, and I don't own Berkshire Hathaway shares)
