Bournemouth, Dorset -- Reports on house prices, inflation, pay awards, unemployment or whatever seem to be coming thick and fast these days, and today it is the turn of high street prices. According to the British Retail Consortium, we don't have to worry about inflation, as prices in that aggregate thoroughfare in August were down 0.6% over the same month last year. The Footsie was cheered by this bit of good news, and firmly set out early on to recover some of its recent losses. Spurred on by big brother Dow Jones when it opened later in the day, it really got into its stride, and ended the day with a smile.
Big news in the banking and insurance world. Following on from recent rumours regarding Lloyds TSB(LSE: LLOY) having an interest in Legal & General Group(LSE: LGEN), it was confirmed this morning that it is actually National Westminster Bank(LSE: NWB) who are talking to Legal & Generalabout a possible takeover. This confirmation pushed Legal & General shares to 205.25p at the close, a rise of 13p. See below for news of NatWest.
Shares in other insurance companies also rose, perhaps on expectations that Lloyds TSB will now rush to snap one of them up. Norwich Union(LSE: NU.) gained 46.75p to 474.25p, CGU(LSE: CGU) rose 85.5p to 992.5p, and even old Prudential(LSE: PRU) got in on the act, pushing up 50.5p to 998.5p. Farmers seem to be in the news today too, as there is so little demand for sheep that they don't know what to do with them. Perhaps they should send them out to buy shares. Or maybe they already did.
Bid speculation is always guaranteed to whip up a froth, and today it was the turn of Greenalls Group(LSE: GREW). The bid in question is a rumoured attempt by Scottish & Newcastle(LSE: SCTN) to buy out all or part of the company. Greenalls' share price had a nice head on it, up 8p to 378.5p, by the time the first evening pint was poured.
Newcastle United(LSE: NCU) perked up on the news that Bobby Robson has been confirmed as the club's new manager, and the shares headed up 3.5p to finish the day on 77.5p. Wonder what he'd look like with dreadlocks?
Sportswear makers Pentland Group(LSE: PND), gained a few pennies today, up 5p to 143.5p after the controlling family announced plans to take the company private. A buyout price of 145p per share was suggested. This came after the company released good interim results. Total pretax profit was reported at £22.4 million against £14.5 million the same time last year, with earnings per share up from 2.29p to 4.09p.
IT companies seem to be in favour at the moment for no good reason. Logica(LSE: LOG) climbed 38.5p to 843.5p and Sage Group(LSE: SGE) gained 167.5p to 3027.5p. Hmm, it couldn't possibly be investors blindly rushing into the sector after Sema Group(LSE: SEM) announced good results yesterday, could it? Surely not. Anyway, Sema themselves gained 64p to end the day on 761p after yesterday's results showed an increase in pre-tax profits from £28.5 million to £38.5 million.
Internet darling Freeserve(LSE: FRE) fell this morning after news broke of another couple of planned Internet company flotations, but came back to finish the day 1p up, on 176p. 365 Corporation, a provider of Internet content, is considering a float in November. UK online auction house QXL.com is also planning to float, with listings on both the London Stock Exchange and Nasdaq.
Finally, The Old Monk Company(LSE: OMC) gained 9p for a closing price of 89.5p. There was no news on the company at all, and they only get a mention because they have such a great name. And before you start wondering, no, they're not in the second hand ecclesiastical business, they run pubs.
Though the company's takeover talks helped to get the Legal & General(LSE: LGEN) share price moving upwards today (see above), shares in National Westminster Bank(LSE: NWB) themselves suffered as a result, and fell 68p to 1143p.
Shares in recruitment specialist HW Group(LSE: HWG) fell in late trading after chairman Richard Mead, at the company's AGM, described its first five months profits as "disappointing." The shares ended down 7.5p on 79p.
Recent requests from British Aerospace(LSE: BA.) for government loans to help it do its bit to build the planned Airbus "super jumbo" didn't impress investors, and the share price initially descended rapidly, but recovered later to end the day down just 1.25p on 472.75p.
There I was, having a nice long bath, and my mind wandered, as it often does. We need yet another theory to explain why stock prices move as they do, I thought. And this is my attempt. If it comes across as half-finished that's because the bath water got a little cold, cutting my thinking process short. I've called my contribution to this overcrowded sector the 'Rubber Band Theory'. We'll go into the reason why a little later. The basis of the theory is that there are two distinct elements in the valuation of stocks.
The first is the fundamental value of a stock. This is the true value of a company at any given point in time. In accordance with classical economic theory, this is the discounted value of all the company's future cash flows. Put simply, the value of a stock now should equal the value of all cash you can take out of the business in the future. Because of inflation and other factors, you reduce the value of future cash flows by a set percentage, often referred to as the cost of capital. This means that £1,000 of cash now is worth considerably more to you than £1,000 in five years' time.
However, there's a big problem. In fact, two of them. First of all, you don't know what these future cash flows will be. Secondly, you don't know what rate to use when you are discounting. You can make assumptions based on historical evidence, but the final value can be very sensitive to small changes in those assumptions. Having said that, you can normally get a figure that seems reasonably sensible. Buffett made a useful statement in this context even though he was referring to overvalued stocks when he said "I don't need to know a man's precise weight, to tell he is overweight". To put it another way, there is no need to be absolutely correct.
This fundamental value, if we take the stock market as a whole, appears to increase over time. If we take the long run return of equities in the UK, then this suggest that the 'real' increase, that is the total increase less inflation, is a shade below 8% per annum. This suggests that, on average, the 'real' fundamental value of stocks doubles roughly every ten years.
The second element of a stock's value is its current rating, most often referred to as the price to earnings (P/E) ratio. The fundamental value of a stock forms the basis of this rating. In reality, and especially in the short term, the price of a stock will kind of monkey around either above or below its true fundamental value. But there is some logic to it. It seems to be attached by a piece of elastic, hence the Rubber Band Theory.
These pieces of elastic can be very long. The price of a stock can drift far away, in either direction, from its fundamental value. But there is a tendency for the price to pull back towards that fundamental value. Often it overshoots, sending a previously overvalued stock to ridiculously cheap levels and vice versa.
Which force should you be concerned with, as a long term Foolish investor? The financial press and the Wise seem to be obsessed with that bit of elastic and devote 99% of their time to predicting it. This stems from the belief that stocks must always be correctly valued. In the papers you often see sentences like "the market is on a P/E of 25 when the W.I.S.E. ratio clearly dictates that a P/E of 20 is the correct value. Therefore we predict an immediate fall in FTSE 100 from its current level of 6,200 to 4,960". What a load of garbage!
The trouble is you never know when that elastic is going to snap back. If you are betting on short term price movements, you are just taking a gamble. The most likely outcome is that the rubber band will snap and take your eye out. It's just not worth the risk. Whenever someone says the 'correct' level for the market is so and so, we can guarantee that they're talking from where the sun doesn't shine.
It seems that it is extremely rare that stocks are ever 'correctly' priced at their fundamental value. And there is certainly no evidence that, once there, they stay there for any length of time. They are wobbling around on that bit of elastic all the time. Take Glaxo Wellcome(LSE: GLXO). In the last eighteen months the price has ranged from 1463p to 2288p. The highest price is 56% above its low point. Is the fundamental value of such a large company likely to have changed by that much in such a short period of time?
If you are a long term investor, I believe you should be primarily concerned with the first of the two elements. That's not to say you should ignore the elastic completely. Obviously you are more likely to get a better return from a stock that is below its fundamental value. And some investment strategies can use the elastic with great effect. Our Beating the Footsie portfolio does just that. It looks for stocks whose prices are stretched so far downwards there is a good chance they will snap back, resulting in a healthy profit. Even so, this strategy is a world away from the daily stock market chatter that thinks stocks should rise because they have underperformed the sector in the last month or sets short-term price targets.
In conclusion, invest over the long term by concentrating on fundamental value. Unfortunately not all stocks grow at the same rate. Some grow much faster and others grow very slowly or even fall. The trick is to pick those with the best chance of growing at the highest rates. In fact, you could say that this is the theory behind our new Rule Shakers portfolio. Here the elastic is ignored and growth in fundamental value is everything. Let me apologise now to TMFPyad and TMFAlan for these gross simplifications of both their strategies.
Not to be outdone by the British Retail Consortium, the Chartered Institute of Purchasing and Supply also got its bit in today. It appears that the UK services sector grew in August for the sixth month in a row. The growth in August was down a little bit from the July growth, and why do you think that is? Apparently, they reckon it was the solar eclipse that did it. What? "Madness," we hear you cry, but don't worry, it's just all those extra holidays that people took to see it (we presumably don't normally take many holidays in August, I guess).
All these reports from such noble bodies reminds me that the Chartered Institute of Curry and Beer hasn't put out a report for quite some time, so a research trip is probably in order. Better stop off at the Chartered Institute of Flush Toilets on the way out though, and make some room.
As always, if you want to hurl lots of words at us, hurl away at the message boards.
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