99 7 The Stock Market Is Smarter Than You Think The stock market’s volatility and the sometimes-erratic pricing of companies’ shares have always raised questions about the link between stock prices and economic fundamentals. Some experts have at times even posited that stock markets seem to lead lives of their own. In 2017 the level of market valuations led Nobel laureate Richard Thaler to comment, “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be nap- ping. . . . I admit to not understanding it.”1 Several years earlier, another Nobel Prize–winning economist, Robert Shiller, wrote, “Fundamentally, stock ­markets are driven by popular narratives, which don’t need basis in solid facts.”2 American investor Bill Gross claimed in 2012 that the last 100 years of U.S. stock returns “belied a commonsensical flaw much like that of a chain letter or yes—a Ponzi scheme.”3 Does it make sense to view the stock market as an arena where emotions rule supreme? We think not. Certainly, irrational behavior can drive prices for some stocks in some sectors in the short term. And for shorter periods of time, even the market overall can lose touch with economic fundamentals. But in the long term, the facts clearly show that individual stocks and the market as a whole track return on invested capital (ROIC) and growth. For this rea- son, managers should continue to make decisions based on these fundamental drivers of value. By doing so, managers can also detect and perhaps exploit any irrational market deviations if and when they occur. In this chapter, we’ll explain how a market with different types of investors can lead to rational prices most of the time, even if some of the investors don’t 1 J. Smialek, “Nobel Economist Thaler Says He’s Nervous about Stock Market,” Bloomberg News, Octo- ber 10, 2017, www.bloomberg.com. 3 W. H. Gross, “Cult Figures,” Investment Outlook (PIMCO), August 2012, www.pimco.com. 2 R. Shiller, “When a Stock Market Is Contagious,” New York Times, October 18, 2014, www.nytimes.com. 100  The Stock Market Is Smarter Than You Think make decisions based on economic fundamentals. Then we’ll show the empiri- cal evidence that growth and return on invested capital (ROIC) are, in fact, the key drivers of value. Finally, we’ll explode the myths behind some commonly accepted beliefs that are at odds with the fundamental principles of valuation. Markets and Fundamentals: A Model We use a straightforward model to illustrate how market trading by both fun- damental, or informed, investors and nonfundamental investors (what we call “noise traders”) will produce prices that are generally in line with intrinsic value but can still be volatile.4 These prices may even deviate significantly from intrinsic value under certain, albeit rare, conditions. Assume a basic market where trading is limited to one company’s stock and, for comparison, a risk-free asset. Two types of investors trade in this mar- ket. Informed investors develop a point of view about the intrinsic value of the company’s shares based on its underlying fundamentals, such as return on capital and growth. They base their buy and sell decisions on this informed point of view. They may not all agree on the intrinsic value. Some may believe the company’s shares are worth $40, others $50, and others $60. Because of transaction costs and uncertainty about the intrinsic value, they will trade only if the stock price deviates by more than 10 percent from their value estimates. The other investors in this market are the noise traders. These traders may be news oriented, trading on any event they believe will move the share price in the near term, without having a point of view on the company’s intrinsic value. Noise traders can also trade on momentum, basing their trades only on price trends: when shares are going up, they buy, assuming the price will continue to increase, and when prices are going down, they sell.5 Say trading starts when the price of a single share in the market is $30. Informed investors start buying shares because they believe the shares should be worth $40 to $60; such buying drives up the share price. Some noise trad- ers notice the rising share price and begin to purchase as well. This accelerates the share price increase, attracting more and more noise traders. As the share price increases, the informed investors gradually slow their purchases. At $44, the most pessimistic begin to sell. Once the price passes $66, all informed investors are selling. Momentum declines, which some of the noise traders sense, so they begin to sell as well. The selling pressure builds, and the stock 4 Nonfundamental investors could be called “irrational” because they don’t make decisions based on an economic analysis of a company. We call them nonfundamental, because their strategies might be rational and sophisticated even though not based on fundamentals. 5 Our two investor groups are similar to feedback traders and smart-money investors, as in W. N. Goetz- mann and M. Massa, “Daily Momentum and Contrarian Behavior of Index Fund Investors,” Journal of Financial and Quantitative Analysis 37, no. 3 (September 2002): 375–389.