Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 498

Why stock prices are a distraction

Stock market prices are like email: they’re distraction machines. With email, it often distracts people from getting work done efficiently. With stock prices, they distract investors from what really matters: the businesses underlying them.

Ralph Wanger, a legendary US small cap fund manager, knew this well. Wanger ran the Acorn Fund from 1970 to 2003, clocking 16.3% annual returns compared to the S&P 500’s 12.1%. He used the following analogy to describe the behaviour of a typical investor:

“There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum.

"At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he’s heading northeast at an average speed of three miles per hour.

"What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog, and not the owner.”

Wanger’s point is that investors are transfixed by stock prices (the dog), when they should focus on businesses (the dog owner).

Put another way, the performance of a business will be ultimately reflected in its stock price.

100 baggers

What parts of a business’ performance should be tracked?

Thomas Phelps, a US-based financial analyst and advisor, had some answers. Phelps wrote a well-known book called ‘100 to 1 in the Stock Market’ in 1972. It was about his quest to find stocks that could increase by 100x.

In the book, Phelps created a table of basic financials for Pfizer over a 20-year period.

Simple stuff.

Phelps then went on to ask: “Would a businessman seeing only those figures have been jumping in and out of the stock?” His conclusion: “I doubt it.”

True enough. The table shows Pfizer sales went up 6.7x over 20 years, earnings increased 4.7x, dividends climbed 3.5x and return on shareholder funds was consistently high, averaging close to 17%.

If you’d focused on Pfizer’s price, you may not have hung on to the stock. The stock had highs and lows, and significantly underperformed the market over a five-year stretch during that period.

And because so many people have been “sold on the nonsensical idea of measuring performance quarter by quarter - or even year by year - many would hit the ceiling if an investment advisor failed to get rid of a stock that acted badly for more than a year or two.”

Bailing on Pfizer would have been costly. The stock went up 25x excluding dividends over the 20 years.

Phelps issued a challenge to his readers:

“The secret of success in your quest for 100-to-one stocks is to focus on earnings power rather than prices. Can you do it?”

Similar strategies

Several current fund managers use similar metrics to Phelps to track business performance.

Warren Buffett’s business partner, Charlie Munger, zeros in on a business’ return on capital to determine whether it can deliver satisfactory returns:

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."

Francois Rochon, a Canadian-based global fund manager, uses a comparable table to Phelps to explain his investment philosophy.

The first thing to note is that Rochon has crushed the market over the long period. He’s done it by focusing on companies that can deliver +15% EPS growth over the long term. In the table, he measures the value of his portfolio by calculating the EPS growth plus dividend yield of his fund holdings each year. The 13.3% annualized return is close to his target of 15%.

Compare that to the S&P 500, which has delivered 8.2% annualized growth in value, as measured by annual EPS growth plus dividend yield.

Rochon’s theory is that the EPS growth plus dividend yield will eventually be reflected in stock prices. And the table demonstrates that he is largely correct.

Terry Smith, a UK-based manager of the highly successful Fundsmith, provides a more sophisticated table of his global fund’s key metrics:

From the table, you can see that Smith is a growth investor who likes businesses with high returns on capital employed (it’s like ROE but includes debt in the calculation), high margins, ones that converts profits into cashflow (a check on whether there’s any funny accounting involved) and have high interest cover (ensuring earnings before interest and tax can comfortably cover interest expenses).

If you compare Smith’s metrics to the S&P 500, you’ll notice that the businesses in his fund have much higher ROCEs, margins, and interest cover, with identical cash conversion rates.

Smith thinks that if he owns businesses with superior fundamentals as outlined in this table, and he buys them at a multiple similar to the market, then he should deliver market-beating returns. And he’s been proven right with his long-term track record.

The Morningstar point of view

Morningstar analysts focus on identifying moats or sustainable competitive advantages. While the assessment may be qualitative in nature the financial statements will reflect the impact of the sustainable competitive advantage. A company with a moat will have a return on invested capital (“ROIC”) that exceeds the weighted average cost of capital (“WACC”). In layman’s terms this means the company will be able to generate a return by investing in the business that exceeds the cost it takes to raise capital. If a company can raise capital at 7% and earn a 10% return the difference will accrue to investors over time.

Buffett’s take

Like so many things in investing, the final word on the topic should go to Warren Buffett:

“Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard. If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”

 

James Gruber is an Assistant Editor at Firstlinks and Morningstar.

 

1 Comments
Julie
March 02, 2023

Love the Wanger analogy. Ignore the noise!

 

Leave a Comment:

RELATED ARTICLES

Is ResMed a trap or an opportunity?

Market narratives are seductive and dangerous

Beware the headlines as averages don’t tell the whole story

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

Latest Updates

Investment strategies

Trump's US dollar assault is fuelling CBA's rise

Australian-based investors have been perplexed by the steep rise in CBA's share price But it's becoming clear that US funds are buying into our largest bank as a hedge against potential QE and further falls in the US dollar.

Investment strategies

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Property

Soaring house prices may be locking people into marriages

Soaring house prices are deepening Australia's cost of living crisis - and possibly distorting marriage decisions. New research links unexpected price changes to whether couples separate or silently struggle together.

Investment strategies

Google is facing 'the innovator's dilemma'

Artificial intelligence is forcing Google to rethink search - and its future. As usage shifts and rivals close in, will it adapt in time, or become a cautionary tale of disrupted disruptors?

Investment strategies

Study supports what many suspected about passive investing

The surge in passive investing doesn’t just mirror the market—it shapes it, often amplifying the rise of the largest firms and creating new risks and opportunities. For investors, understanding these effects is essential.

Property

Should we dump stamp duties for land taxes?

Economists have long flagged the idea of swapping property taxes for land taxes for fairness and equity reasons. This looks at why what seems fairer may not deliver the outcomes that we expect.

Investing

Being human means being a bad investor

Many of the behaviours that have made humans such a successful species also make it difficult for us to be good, long-term investors. The key to better decision making is to understand what makes us human and adapt.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.