Emotions can be both the turbocharger, and handbrake for your investing wealth, writes The Motley Fool.
I'm sure you've read Benjamin Graham's often quoted view on the share market…
"In the short-run it's a voting machine, but in the long-run it is a weighing machine".
Wise words indeed, though for various reasons many investors focus on the weighing machine and ignore the voting machine. I think that is a mistake.
I find equal value in both parts of Ben Graham's wisdom and am always trying to profit from both the voting and weighing machines. After reading this article, I hope you'll see why it is a mistake to ignore the voting machine.
There are two primary reasons why the voting machine is so important. Investor sentiment – the voting machine – is both the turbocharger and handbrake for your stock positions.
Two ways to profit
There are two ways to profit in the share market.
Your company can increase earnings, thereby increasing the company's value. Or the price someone is willing to pay for each dollar in earnings could increase.
The price investors are willing to pay for earnings are called multiples – examples include price to earnings (P/E) and enterprise value to earnings before interest tax and amortisation (EV/EBITA).
When investors pay more for the same earning the multiples increase. That's called multiple expansion.
To quickly recap, investors profit when underlying value increases or what investors are willing to pay for the same value increases.
Some value investors argue there is a third way. They argue that by buying a company at a discount or margin of safety to their calculated intrinsic value, they profit when the gap between the share price and business value narrows.
While that is a great philosophy, the narrowing of the gap comes from increasing multiples. Don't get me wrong. I have a value streak a mile wide. I love a bargain and even prefer to buy growth companies at a discount.
Buying companies with a wide margin of safety is surest way I know to profit in the stock market. However, a narrowing of the gap between value and price is simply a subset of multiple expansion. So we are left with our two ways to profit.
Pedal to the metal
I call my favourite shares double bangers. They have the accelerator pressed to the metal and the turbo is kicking in.
The best performing shares belong to companies that are both increasing value and have increasing multiples. Investor sentiment is the turbocharger. While value changes slowly, investor sentiment changes swiftly, and along with it, multiples expand quickly resulting in share prices shooting up.
Beware the handbrake
Conversely, multiple compression – investors paying less for the same earnings – is the handbrake. While the value of a company can keep increasing, falling multiples can rob investors of the returns they believe they deserve.
Just ask anyone who invested in Microsoft or WalMart a decade ago. Those investors have seen revenue and earnings increase dramatically while the share price has gone nowhere.
In growing companies multiple expansion can happen rapidly, whereas multiple compression is more like death by a thousand paper cuts. It's slow and painful. Earnings increase, but the share price goes nowhere as the multiples compress.
Foolish bottom line
Investors should load up on companies with value creation and multiple expansion opportunities and avoid companies likely to suffer from multiple compression. If you can do that you'll be on a good path to a successful lifetime of investing and wealth creation.
I began by quoting the father of fundamental investing, Benjamin Graham. I'll close by quoting the lesser known investor.
"Wise Fools rightly disdain only looking forward one quarter. However, as many investors have the attention span of an ADHD kid supercharged on Coke, it's good to consider what they'll next focus on." Dean Morel (me!)
The voting machine is as important as the weighing machine. That's why I spend my time searching for undervalued companies with catalysts to kick the voting machine into turbo. The elusive double bangers are waiting to be found.
Dean Morel is The Motley Fool's Investment Analyst. He is looking for double bangers in the Australian and U.S. sharemarkets and has no positions in companies mentioned in this article. The Motley Fool's disclosure policy has low volatility.