What Drives Stock Returns? (Divergence Analysis)

Two friends- Rajesh and Suresh, were returning home after a long and tiring day at work.

Rajesh, who happened to be an active investor in the market, turned to Suresh and exclaimed “Avanti Feeds share price has fallen down so much in the last 6 months, it destroyed all the gains it has generated in the last one year. How could this happen?”.

Suresh, a calm and a seasoned investor, who has seen multiple market cycle– listened patiently to Rajesh’s rants but kept reading his novel.

Perplexed by Suresh’s lack of response to his situation Rajesh asked “How can you remain so calm in this market, Suresh? Hasn’t the contagion affected the stocks in your portfolio too?”.

Seeing that he could no longer escape the onslaught Suresh replied– “Yes Rajesh, stocks in my portfolio have also been affected by the ongoing contagion… But I don’t bother much about that because I stayed away from the markets when it was reaching premium valuations. The contagion effect has had only a mild effect on my portfolio.”

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How many of us have been able to remain calm during the market volatility that we have witnessed in the last six months? Why is it so hard to remain stay put with our investments even when we had high conviction when we invested in them a couple of years ago? 

In fact, what causes the price of a stock to change so drastically? And what can we, as investors, do to prepare ourselves for it? This is exactly what we seek to address in today’s post.

We shall try to understand the various components of stock returns. How each divergence between the components can be used to gain a broader understanding of the market as well as the expectations placed on the script by other investors.

The topics for this post are as below:

1. What are the components of stock returns?
2. How do the different components affect the share price?
3. Could the divergence be used to explain how the mood swings in the market? 
4. What time period should be used for the divergence analysis?

This is going to a little longer post. But it will be worth reading. So, let’s get started.

Finding Stock Returns Using Divergence Analysis Toolkit:

1. What are the components of stock returns?

Everybody knows that the value of a company is driven by the underlying growth in its earnings.

But, the prices of a stock don’t just depend on the performance of the company. It also depends on the expectations of the investors and the underlying mood regarding the broader economy.

If we were to bring out an actual formula for stock price return for a company it would look something like this –>

Total Return =  Fundamental Return + Speculative Return + Dividend Return + Inflation in the Country

2. How do the different components affect the share price?

The dividend returns are a small component of the overall return achieved from a stock. If the company gives a very little or no dividend, then this component is literally doled out by the company.

The inflation return, however, happens to the black box. But, for growing economy like India, it suffices to take the inflation returns close to 5%.

Now, this brings us to the remaining two components of the equation. The Fundamental Return and the Speculative Return. From empirical evidence, it is has been broadly understood that close to 80 percent of stock returns occur just from these two components.

In a bull market, the speculative return goes over and above the fundamental return. While in the bear market the speculative return goes well below the fundamental return.

Let’s understand this from the example of Avanti Feeds. It was a hot stock in 2017, which means that it was basically a recipe for portfolio disaster.

(Source: TradingView)

For simplicity of calculation let’s assume only the role played by fundamental and speculative return components in our equation.

Total Return =  Fundamental Return + Speculative Return

This equation could also be represented as,

Speculative Return = Total Return –  Fundamental Return

From financial and the stock price data we have created the following chart for our analysis:

*(Chart and table are scaled to show the returns starting from March 2014 and adjusted for stock splits and bonus issues. All financial data are shown on the preceding 12 months basis.)

From the above analysis, it becomes clear that whenever the overall stock returns exceed the fundamental returns produced by the company– the stock prices have seen a correction to the true levels denoted by the fundamentals.

3. Could the return divergence be used to explain how the mood swings in the market?

And is it really possible to time the market?

If the above analysis were to be repeated for every single company in the broader market indices, it could give a pretty good idea regarding the ebb and flow of investors’ money into and out of the market.

A possible combination of the PE multiples for the indices with the divergence analysis could be better used to indicate the overvalued/undervalued status of the market. And this may serve as a leading indicator for bull runs and market crashes.

Also read: Investment vs Speculation: What you need to know?

4. What time period should be used for the divergence analysis?

Since most market cycles last around 5-7 years, we at tradebrains, believe that it suffices to use 5-7 years of data for performing the divergence analysis.

But since a lot of stock splits and bonus issues take place in the markets every year, investors should account for these events in their analysis and use only price data that has been adjusted for these special events.

Closing Thoughts

The financial market, despite on a core level is powered by the fundamental returns generated by a company, it tends to fluctuate wildly from the fundamentals due to cycles of greed and fear that are chained to money investors put into the capital markets.

The divergence analysis can be used in this scenario to understand the cycles and be used as an indicator to make key capital allocation decisions on whether to keep away from the markets or build cash or sell your existing stock positions.

We hope you enjoyed this read, looking forward to your comments. Happy Investing.

Levin Jenson

Levin is a former investment banker and a hedge fund analyst. He is an NIT Warangal graduate with around 5 years experience in the share market.