Share prices must be supported by fundamentals

“Shares should rise in price only if there’s good reason to think future profits will be high. As we know, profits derive from scarcity; for instance, ownership of scarce land (protected by legal title), a scarce brand (protected by trademark) or an organisation with unique capabilities (protected by nothing more than the fact that most effective organisations are hard to copy). So share prices should rise only if economic transformation increases the degree to which organisations control scarce resources.”

Tim Harford, The Undercover Economist

We are developing a mania about buying and selling shares in this country, and Tim Harford, author of the popular and thought-provoking book The Undercover Economist provides a necessary reality-check.

It is easy to forget: when you buy a share in a company, you don’t buy a share in confirmed riches. You buy a right to have a share in the future profits of a real company. The potential long-term profits of the company are called its ‘fundamentals’ – and in the long run, share prices must reflect these fundamentals.

Harford is reminding us that long-term profits are about what economists call scarcity – or what managers with MBAs call uniqueness or distinctiveness. In the past, scarcity was about access to scarce resources such as minerals, or about companies being given monopoly licenses. Those companies made a killing – and kept making it year after year, as the scarcity that underpinned their business did not really change. You would have done well buying shares in those companies.

But things are different today. Monopolies are frowned upon because of their tendency to abuse customers and stifle innovation (look at the recent past of our telephony and power providers to see the truth of this). These days, economic policy-makers favour more liberalised regimes with more competition. More players, less scarcity.

Today’s great companies try to construct a different type of scarcity: they build strong brands that are difficult to match; they develop unusual capabilities over time; they rely on a capacity to innovate and keep innovating. These are more subtle – but often equally strong – competitive advantages. They have the same effect: they bestow a steady stream of profits on the firms that develop and sustain them.

The lesson for the share-buyer is obvious: consider the uniqueness of the company you are investing in, and consider the possibility of that uniqueness being lost. If your target company has a ‘me-too’ ordinariness, it is unlikely to deliver extraordinary rewards. If it is likely to face intensive competition in the future, its current profits will be whittled away.

If, on the other hand, the company you’re eyeing does things differently and better than others, you may be on to something. Does it have unrivalled delivery of great customer service? Does it understand the subtleties of people management better than its competitors seem to? Does its brand possess a panache and command a premium that others would die for?

When all is said and done, it’s the companies that do things better by being different that offer a good chance of long-term profits. So if you want to buy shares for the long run, don’t listen to your stockbroker: study the company’s management philosophy, listen to its customers, examine its business model. Those are the things that really matter, not the weekly gyrations in the share price.

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