where does past performance matter

So, what does this recent roller coaster ride mean for future stock prices? Nothing. Well, almost nothing. Let’s discuss where past performance does matter.  

Stock prices are determined by supply and demand. If the demand for stock shares for a particular company increases relative to the supply, then the price increases. And, if the demand decreases or current investors no longer want to hold the stock, the price decreases. The question is: How do you know if demand will increase or decrease in the future? 

The price an investor pays for a share of stock should depend on the company’s prospects looking forward. Countless factors carry weight in determining the outlook for any given company. Economic conditions may determine how much disposable income consumers have, which may drive or decrease a company’s revenue. Geopolitical developments can affect the prices a company pays for its raw materials, which could then affect net profits. Unpredictable events ranging from natural phenomena like weather events to political or social media situations can be huge strokes of luck for a company – both good luck and bad luck. These factors have nothing to do with past performance. 

So, where does past performance matter? 

An area where a company’s past performance may be useful in forecasting future performance is when evaluating management. Many factors are out of a company’s control. However, the ability of a company to respond beneficially to these situations should factor into the stock price. Has management responded prudently to problematic times in the past? Have they appropriately taken advantage of times of economic growth? Does the current management have a track record to evaluate? Has management anticipated and planned for potentially difficult times? For instance, does the company have cash on hand to ride out economic downturns, or will they have difficulty making interest payments on money borrowed to expand during good times? 

past performance of management

Management in large, publicly traded companies provides a great deal of information in required filings and often hosts earnings calls. These calls allow management to respond to questions from analysts and other followers of these companies. They also allow leaders to provide some insight as to how they see their companies performing in the future. Corporate executives will often report on trends that their economists see and how they expect those trends to affect sales or expenses. They frequently report on headwinds and tailwinds that they expect the company to face in the near term and the long term. In fact, the insights and comments of well-respected corporate leaders can affect the market far more broadly than just their own companies. 

You might have noticed that during the most recent earnings season, the stock prices of many companies declined even though their results met or exceeded expectations. Strong earnings performance is often a reason to believe that a company is doing something right and will continue doing so. But, even more critical is a company’s ability to read its market and adapt. As executives raised concerns about the economy going forward, it may have caused some alarm among investors. This would likely affect stock prices. The questions are – Are the economists interpreting the data correctly? And, is management taking appropriate steps to prepare their companies to prosper in the uncertain times ahead? 

The interesting thing about that last question is that we ask that question all the time. We asked that question in the summer of 2011 as the market declined steeply before climbing yet again. And again with the declines at the beginning of 2016. Yet the S&P 500 finished the year with a total return of 11.96% in 2021. The fourth quarter of 2018 saw some dismal stock performance, and the S&P 500 finished the year with a -4.38% total return for the year. Many were saying that we had finally come to the end of a long bull market. Between then and the middle of 2019, the S&P 500 was up more than 18%. Since then, we’ve lived through an unprecedented global pandemic, and now, we’re still in the recovery phase from that event. How do you evaluate management’s ability to respond to such an unprecedented situation? 

Statistical analysis is imperfect. Economists can evaluate their data models and make projections for anticipated situations. However, no data model accounts for every single factor and every interaction that can affect outcomes. Therefore, sometimes the models don’t foretell the true economic situation. 

Corporate leaders are aware that economic forecasting is imperfect. They need to incorporate their beliefs about the plausibility of each of the forecasts into their marketing, operating, and financing strategies, drawing on their own education and experience and incorporating hard data. 

The challenge for management is to position their companies to remain strong regardless of economic and geopolitical conditions. This often means forgoing some potential near-term growth in order to divert some resources to downside protection. The intent is that, when it comes to earnings, while the highs may not be as high, the lows shouldn’t be as low. While a company could deploy all of its resources to aggressive growth during periods when the economy is strong, it may find itself in an unsustainable position as the economy contracts. A management team’s ability to find the right balance and provide consistency and dependability in reacting to market conditions is a huge asset to a company. This is where evaluating past performance makes sense. 

This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. We examine these factors and many others during our financial planning process to determine appropriate financial strategies for YOU.

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