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Speculation, Fundamentals, and Valuation
January 11th, 2008
Stocks usually trade based on either fundamentals or speculation. Some might refer to fundamental investors as more 'fearful', while speculative traders are more 'greedy.'
I prefer to think of it in terms of focus. Fundamental investors are mostly focused on the company right now, while speculative traders are concerned mainly with what the company could become.
What becomes interesting is when a company's valuation method shifts from one to the other. Often a change from fundamentals to speculation will result in upside momentum on the stock, while going the other way can be bad news for share prices. While not always true, there is a definite and noticeable trend.
There are many examples I could use to clarify my point. For now, let's look at the satellite radio companies XM (XMSR) and Sirius (SIRI). Both are fundamental messes. (For those of you who have been following me for a while, you'll know I love to rag on these two).
With about a billion in debt each, new competitive technologies springing up daily, a decrease in retail sales... well, you know what, I could go on all day. I'll leave it at that and get back to my point.
Right now SIRI and XM are trading almost exclusively on speculation. Mainly the potential of growth in satellite radio listeners, and even more so the proposed merger of the two companies, which would result in lots of cost savings coupled with an instant drop-off in satellite-based competition.
However, for investors I think that this may be an anti-climatic story. The potential merger has done two things. First it has distracted traders from the all important underlying fiscal health (or lack thereof) of the companies. Second, it has delayed investors from selling shares as they wait for the magical day that will see the merger approved.
Unfortunately for those investors, they aren't ready for the "shift." The shift from valuation based on speculation to valuation based on fundamentals.
With most companies that undergo such a transition, they very often start trending down to align better with their fundamental situation. In the case of companies with an excellent speculative story, but a brutal fundamental story, it can get ugly.
Even if the merger is approved, it would represent the end of the speculative era for satellite radio. While the merger would be a good thing for them, it will not be so for the stock. Post merger, the satellite radio companies will have to trade based on fundamentals. If you've seen their fiscals, you'll know how that might go.
Always watch for the shift from speculative valuation to fundamental valuation. It happens with every fast growing company as it matures. IBM, Microsoft, you name it...
Remember that speculation is a shareholder's friend. Yet when speculation abandons a stock, it will really force investors to take a long look at what they really have.