Why Do Fundamentals Matter?

With a booming market, everyone forgets fundamentals.  Someone, the other day, told me that “You don’t need profits to pay bills” when talking about Amazon.  If that’s not a sign of euphoria and not understanding how wealth is built, I don’t know what is.

The reason fundamentals matter in the long run is that wealth is built on cash flow, profit, and overall returns.  Yes, a company can profit but if you’re paying too much for that profit, it’s going to hurt you in the long run because there will be a time when your investment is out of style and everyone will revert back to to fundamentals.  It happens in every bear market.  People flee the exciting fast growing stocks that aren’t doing as well financially to go to companies that generate cash flow and build their balance sheet.

Not only in stocks.  Real estate as well.  The last 15 years have been a boom in real estate, even after a big bust.  Real estate is driven by income.  I randomly pulled 28 markets that I could think of in this country and looked at their median income growth and their real estate value growth since 1990.  The direct correlation from one city to another wasn’t exactly there, but when you looked at all 28 cities as a whole, they were very much in line.  Median income growth was 2.32% per year on average and the average real estate growth was 2.6% per year.  Not exact, but close.  During the recent 15 years of booms in major markets (that were also in my 28 city analysis), we were seeing 15-20% growth per year even though income wasn’t growing NEARLY as much.  Then we saw a massive drop in prices and another rebound, so everyone assumes that the past problems were past problems.  We shall see.

The bottom line is that everything reverts to the mean.  We are never exactly fairly valued. We are either overvalued or undervalued in every investment asset.  You are either a buyer or seller of assets.  It’s that simple.

I choose to wait until asset prices get to the point where they are undervalued enough to make me feel that above average returns will be experienced based on historical averages.  Does it require A TON of patience?  Absolutely.  Is it frustrating at times?  100%.  To hear the so-called “experts” tell me that I’m missing it and I don’t understand and “This time is different” has become annoying.  But I stick to fundamentals.  And at the end of the day, they win out.

Fundamentals are the only true way to measure value.  You have to find out what truly defines the price of an asset and buy when the asset is selling for below that fundamental point.  Is it just one thing?  No.  But is it a ton of complicated points?  Absolutely not.  There are a few things that matter when looking at investments and it is the job of a true investor to understand what those are and where they have stood historically (not just over 25 years but over 60+ years).

Is the Stock Market Rigged?

I overhead someone today saying that no one can beat the market because the “whole system is controlled by the wealthiest people in the world and they’d never let it fail.”  To be honest, that’s probably one of the dumbest things I’ve ever heard.  Especially during a roaring bull market. I heard it a lot in 2009 when stocks were down a ton and everyone was saying that people who controlled money caused the crash so they could buy stocks very cheap and make a ton of money while the little guy lost everything.  <eye roll>

The stock market is not rigged, in general.  Are there shady things happening within companies that cause certain things to appear rigged or may actually be rigged?  I’m sure there are.  There have been in the past and there’s no reason that has ended today.  The entire 2009 financial crisis, if you read all about it, is a massive cluster f**k of a bunch of Harvard MBAs who thought they were smart and created financial instruments that were recipes for disaster when they forgot about fundamentals…

If the market was rigged, it would never go down because there are only a handful of investors who WANT the market to go down so we can buy stocks cheaper.  The rest of the people (billionaires included) want to see stocks go up because when stocks are up, their brokerage accounts are up, and they are “richer.” It’s logical.

In addition, the market goes into long (secular) bull and bear markets.  What is the logic behind a group of people conspiring to make the market go sideways (secular bear) for 15-20 years? Just think about that for a second.  You have SO much power to rig a $20 Trillion institution and your first order of business is to make it go sideways for 20 years…how is that helping you out?  And then one day, valuations are so low that the next 20 years sees 15% growth per year!

The market isn’t rigged.  Human beings are lemmings.  They don’t stick to fundamentals and they just buy what their neighbor is buying or what they see on TV going up and up and up. Don’t blame the ups and downs on a few guys conspiring in some back room to make their wallets bigger.  The best investors in the world were average people and are mostly average people who just happened to invest very well.

How Do You Short a Stock? What Does Shorting a Stock Mean?

So I have done this strategy a few times…a couple of times it worked out well and the other two…I am still waiting for my payday. But when I tell people in my office or my friends that I have shorted a stock, they sometimes ask me what that means, and other times I can tell they don’t know what it means…so here is what is being done:

So first off, when I say I am shorting a stock, it means that I am betting that the stock’s price will fall.  So how do I bet that a stock will fall when shorting?

Well, I go to my broker and I say, “Hey Mr Broker, I want to short 100 shares of ABC Corporation because I think it will fall below the current price of $50 per share.”  So what Mr. Broker does is he first looks and makes sure that my account can afford to lose big money because in shorting, as the price of the stock goes up, I lose money, so theoretically, there is unlimited loss potential. Once he has realized I don’t bet more than I can lose (usually), he puts the trade in for me.

But what happens behind the scenes?

Well, the broker finds other clients who have 100 shares of ABC Corporation in their portfolios and they let me borrow those shares from those clients and sell it on the open market at $50 per share.  So I, technically, get $5000 in my account when shorting, but I also owe $5000 to those customers who I borrowed their shares from.  The shares could also be the broker’s own in house shares, by the way.

So I have a net $0 change in my account because I borrowed $5000 and then sold $5000 so the net asset change is $0. So now, if the stock goes DOWN in price from $50 to $30, I can then buy those 100 shares back on the open market for $3000 and replace the 100 shares I borrowed at the lower cost of $3000, so my net is $2000.

Did you follow that? So I borrowed shares at $5000 and then replaced them at $3000, so I net $2000 in profit!

And if the stock goes up, that’s how I lose money.  I borrowed those shares at $50 and I had to buy them back on the open market at $80, which means I spent $3000 more than I borrowed them at, so I lost $3000.

Someone asked me once if that’s legal.  Ha.  Yes, it’s legal.  The bank, theoretically, won’t let you short more than you can afford to lose or anywhere close to what they have in their inventory of stocks.

This is a very risky strategy if done without hedges in place.  But it can yield some high returns if done with the right timing…Which I haven’t done as of late.