Philosophy

It is not only various market capitalization indices and sectors that exhibit cyclical behavior, but also individual companies experience them over time. The conundrum at hand can be comprehended by examining the following two charts, which compare (a) the expansion of a business’s fundamental value (measured through EPS growth) to (b) the growth in its share price. The chart on the left depicts the perception of an investor, whereby the growth in fundamental value of a business and its share price are assumed to be closely correlated. This suggests that upon identifying a business that consistently delivers growth in fundamental value, the share price growth occurs in tandem. For instance, if the fundamental value of a business increases by 20% each year, the share price is expected to rise by a commensurate 20% annually. The chart on the right illustrates what transpires in reality, which often differs from an investor’s initial perception. Even if a business is identified that has the potential to grow its fundamental value by, say, 20% annually, the growth in share prices is not necessarily synchronous each year. In the first phase, the markets tend to become excited upon discovering such a business, causing the share prices to surge ahead of fundamentals (point A through B). However, at a certain point (point B), the market realizes that it is paying an excessive premium for what is being offered. Consequently, while the fundamental value continues to rise, share prices remain stagnant for an extended period (till point C). This phase between points B and C could easily extend for ten to twenty years.