Myth or fact? Stock market investing is just gambling

It is natural to doubt the very foundation of the stock market during times of higher volatility and flat or negative returns. Some may even think that stock market or equity mutual fund investing is just gambling and does not have any sound basis. In fact, when NSE started operations in the year 1994, a prominent newspaper announced it with the headline saying: the country's "biggest casino is born". And there are people from the older generation who still believe this! Are the stock market movements really random or do they have some solid foundation? Are the world's top long-term investors really just lucky or have good stock selection criteria backed by conviction? Let's evaluate this by looking at whether companies' real-world business performance determine their stock prices. Specifically, let's look at which fundamental metrics could eventually determine stock prices.

When it comes to selecting a performance metric of companies for evaluation, intuitively we first think of earnings growth of the company. The company would re-invest earnings back to fuel the company's further growth, resulting in the effect of compounding their investors' returns over time. So, we may expect that investors would generally be willing to invest in companies in proportion to their earnings growth. Of course, there would be many other quantitative as well as qualitative criteria that are likely to contribute to the stock prices growing and could be part of the stock selection process. For now, let us try to look at the Earnings Per Share (EPS) growth in relation to stock prices of companies comprising the NIFTY 50 Index as a whole, and see if we can find a pattern based on the last 20 years data.

Data Source: TrendLyne

From the chart, we see that earnings growth and growth in stock prices of companies tend to move closely together over the long term. In terms of numbers, the annualized growth rate (CAGR) is nearly the same for both of these over 20 years as shown above. This indicates that ultimately, a company's real-world business performance does determine its true stock value.

Does this mean that we can predict stock market movements with 100% accuracy? Unfortunately not, because there are many other factors which come into play, especially in the short term. For example, news headlines, expectation outlook, FII and DII activity, prevailing interest rates, global conflicts, regulatory changes, tax updates etc. could all affect the stock market in the short term.

In conclusion, the time-tested market wisdom is best summarized in this modern paraphrasing of the famous quote by "the father of value investing" Benjamin Graham:

In the short run, the market is "sentimental" and in the long run, it is "fundamental"!