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Markets are a lot less mechanical and calculating than we generally think.
Prices for stocks, bonds and commodities are set in markets. These prices are heavily influenced by the mood in the given market place. This market ‘mood’ often outweighs any considerations that we might give to the economic fundamentals of a stock or commodity. I am using the word ‘mood’ loosely. I really mean the specific internal dynamics of a market, that is, liquidity conditions, positioning, sentiment et al.
I will demonstrate this in two ways. First we can take a look at how moody the oil market can be. Secondly, I will use a simple thought experiment in the stock market.
Oil Crisis or No Oil Crisis?
I remember the oil crisis of 1979. My father had a petrol (gas) station. He had to ration out petrol to customers. It was a worldwide phenomenon. If a petrol station opened, cars lined up for hours.
Oil prices moved from about $15 a barrel in January 1979 to almost $40 in April 1980. In this episode the fundamentals and narrative supporting higher oil prices were reflected in the market price in international oil markets.
In 2007/ 08 Oil had another spectacular price rise. In January 2007 Oil traded as low as $50 a barrel. By July of the following year it hit a high of $147. This tripling in price even exceeded the 1979/80 move. However, there are no photographs of empty petrol (gas) stations from 2007 to show. There was no shortage of oil.
This upward move was a creation of the market place dancing to the tune of its own fiddle. By Christmas 2008, a mere 5 months after the high, oil was trading as low as $32. In January 2007 it started at $50, what explains the spike in the middle?
Capital markets have a habit of doing their own thing while blithely ignoring the fundamentals. They will create their own story and take prices to where they will. Just like the trader in the photograph above, market participants have their own agendas. Their bullish or bearish moods often have more bearing on an asset price than the fundamentals.
A Thought Experiment - Tesla V Tandem
I decided to attempt to value a company without first looking at its market capitalization. It is a simple reverse engineering experiment. I’m sure most stock market analysts are cognizant of a market’s valuation of a company before they start their analysis. In fairness it would be almost reckless to estimate a companies valuation without bothering to check what the market thinks. This is exactly what I decided to do.
I randomly decided to go for a bicycle making company and started googling, I found Tandem Group. This British company is listed in London and they have a great story. They make electric bikes and electric scooters. Their last published results (H1 2021) show that revenues are up 14% and profits are up 9%. See below some highlights from their recent results.
Group revenue growth driven by:
exceptional progress in e-scooters +980%
e-bikes up +81%
growth in FOB +15% with resurgence of national retailer confidence in both licensed and own brand
exponential growth in golf business
Gross profit up despite disruption amongst Far East supply base (factory shutdowns, component supply chain delays, cost increases, adverse RMB/USD) and ongoing freight issues(freight cost, container availability, port closures, blank sailings)
Using round numbers, their annualized revenue is £40m, from which they make £4m profit. They have a great balance sheet showing a net cash position of £2m. They even pay a dividend (1.5%). If I asked a team of stockbrokers or investment banker to assign a value to Tandem, what would they come up with? A handy rule of thumb is to multiply the profits (£4m) by a conventional amount. The 500 stocks that make up the S&P index trade at about 25 times earnings (PE Ratio = 25). This would value Tandem at £100m. The UK FTSE 100 Index and the FTSE 250 Index trade on P/Es of 15 and 16.5. Using this we get a valuation of £60/65m. If market darling Tesla can trade on a P/E of 337, why not Tandem, its got a great story? Could it be worth £1,348m? The official Great O’Neill guess was £75m. What is yours? I will reveal the market’s valuation at the end!
We can see very easily that Tesla’s stock market value is in no way related to the financial fundamentals OR the story. The Tesla motor company is 25% more valuable than Toyota, Volkswagen, Ford, General Motors, BMW, Honda and Hyundai combined. As you might imagine, Tesla does not sell as many cars as the aforementioned car makers. In fact, Tesla’s revenue is a paltry 1% of these established car manufacturers. It is likely that Tesla’s market valuation tells us more about the marketplace ’mood' and less about the stock itself.
Conclusion
What was your guess for Tandem’s market value? Did you give it an American (S&P PE 25) style value of £100m or did you go with a more prudent UK style valuation of £60? The Great O’Neill guessed £75m. The actual value assigned to Tandem by the market at the time of its last issued results was £30m for a PE of 7.5. The US stock market doesn’t give a hoot about Tesla’s fundamentals any more than the UK stock market cares about Tandems numbers. Each market has its own mood. Sometimes the market is simply bored and disinterested (Tandem).
The 2007/08 Oil market was excitable and volatile, amazingly bullish, and then amazingly bearish. In a pitch perfect example of opinions following price, Goldman Sachs called for $200 Oil in May 2008. This is an excerpt from a Reuters report (May 6, 2008):
“We believe the current energy crisis maybe coming to a head, as a lack of adequate supply growth is becoming apparent, ”Goldman said in the note made available to Reuters on Tuesday.
Oil hit a new record near $121 a barrel on Tuesday, continuing an advance which has seen it double over the past 12 months.
“The possibility of $150-$200 per barrel seems increasingly likely over the next 6-24 months, though predicting the ultimate peak in oil prices as well as the remaining duration of the up cycle remains a major uncertainty,” Goldman said.
Six months later Oil was trading at $32 a barrel.
Markets are a lot less mechanical and calculating than we generally think.
