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The Volatility Conundrum, or When Good Companies Make Bad Stocks


By the fundamental analysis above, one would expect investors to have made a killing on this company since 1998.

I was looking through some databases of financial information on public companies recently and came across a company that has had absolutely stellar financial results. They have grown revenue and earnings on a compound basis in excess of 30% per year since 1998; moved from a 7.8% market share in 1998 to capturing 18.2% market shares since, making them #1; have used trivial amounts of debt (current ratio and total debt to equity have averaged 1.03 and 10.2% respectively in the last 8 years); have managed their receivables and inventories in a near record fashion (days sales outstanding 30.8 and inventory turns 77 times/annum on average since 1998); have produced fantastic returns on assets, capital, and equity of 15.1%, 41.7%, and 52.9% respectively over the last 8 years; and have done all of this while maintaining superb gross and net margins in an industry noted for its cutthroat economics: averaging 19.5% and 6.45% gross and net margins since 1998.

To the above financials add a maverick, visionary founder/chairman, a strategy that has literally changed the value chain and operational characteristics of the industry in which they operate, and more than doubled their industry market share, becoming one of the top players in the industry by revenue.

By the fundamental analysis above, one would expect investors to have made a killing on this company since 1998: business has been strong and stable; they have managed cash, debt, receivables and inventories incredibly well; they have become a leading market share player and have succeeded in changing the operating landscape of the entire industry in which they operate; and they have delivered steady, strong gains in revenue and earnings.

But here's the rub: since June of 1998, this company's stock has gained precisely 0% and has also paid exactly no dividends. You have made nothing, despite the comfort of seeing earnings compound every year at double digit rates.

There are many lessons in the above, not least of which is that fundamentals can be (and often are) meaningless. For 40 years the academic community has been trying to figure out why the volatility of a company's stock exceeds the volatility of the company's fundamentals by, on average, a factor of 4 (and in many cases orders of magnitude). And in those 40 years not one study has been produced that explains that conundrum. Not one.

That volatility conundrum – that 'gap' between the volatility of the earnings and the stock price – is telling you something. Something important. And it is this: markets are not efficient; stocks do not follow fundamentals, and absolutely nailing revenue, earnings, debt ratios, market shares, etc. will tell you next to nothing about the stock price.

Just ask anyone who has held Dell (DELL) since June 1998. With precisely nothing to show in those 8 years, they are intimately familiar with the 'volatility conundrum.'
Position in DELL

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