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Investors in 3D Systems Corporation (NYSE:DDD) could benefit from a discussion of reflexivity in stock prices.

Companies engaged in reflexive processes possess a two-way relationship between the stock price and fundamentals. The stock price itself can be viewed as a function of perception and fundamentals.

When fundamentals improve, the perception gradually turns positive, and the stock price increases. Management can use positive perceptions to provide cash flow for growth either through stock sales or debt issuance, which eventually cause higher earnings. Thus, perceptions and the fundamentals mutually reinforce each other.

However, eventually the positive bias gets ahead of itself, and the earnings cannot keep up with expectations. The disappointment causes the stock price to fall, which reduces management's ability to raise cash flow for growth, leading to a decrease in earnings, and, in turn, more disappointment. This speeds up the crash of such reflexive processes, creating a boom-bust phenomenon.

First, let's establish that there is reflexivity at play in 3D Systems Corporation.

The company has been running at a negative free cash flow. Though it does generate operating cash flow, it has been aggressively growing via acquisitions and capital investments. It funds these investments mostly by selling stock.

3D Systems Corp Cash Flow Summary for Last 5 Quarters:

DDD Cash Flow for Last 5 Quarters

(in millions of dollars, quantities irrelevant to the discussion removed)

Because DDD has been selling at such a high multiple of earnings (the P/E ratio currently sits at 77), it is advantageous for the company to sell as much stock as possible, to generate cash for growth.

However, it is now generating more than twice as much cash from stock sales as it is from operations. This means that any decrease to the stock price can have a dramatic effect on the company's future growth plans. On the other hand, if the stock continues to appreciate, the company can get even more aggressive with growth initiatives, and boost earnings further.

Since there is a reflexive connection between stock price and the fundamentals of the company, and the connection is a positive correlation, it qualifies as a potential boom-bust process. George Soros outlined the stages of such processes in his 1985 book, The Alchemy of Finance. Shown here is a replica of his model:

George Soros

In stage 1, the trend is largely unrecognized. In stage 2, early investors begin to recognize the trend, and the trend and perception reinforce each other. Stage 3 is a test of the trend and price moves. If the trend survives such a test, the perception and trend both become so strong and mutually reinforcing that the normal rules of stock analysis no longer apply (Stage 4). This continues until the "moment of truth" when the excesses of the boom are recognized (Stage 5). Usually, there is a twilight period (Stage 6) before another event spurs the short-sellers to begin in earnest (Stage 7). Stage 8 is the acceleration of the bearish movement by reinforcing negative perceptions and negative fundamentals. This movement often overreacts to the downside, leading to a slow rise afterwards.

As shown above, the stock price tends to increase faster than earnings during the boom phase (stages 2-4). In 3D Systems Corporation's case, the 2012 Q3 earnings increased 87% year-over-year, while the stock price increased 140% over the same period, providing some additional evidence of the relevance of this model.

I believe stage 3 has already occurred. Grey Wolf Research's article, which made various allegations such as channel-stuffing and overstating the organic growth rates, provided the impetus for a ~20% decrease in stock price - a test of the upward trend.

However, management responded, and the subsequent rise in stock price shows that the response was enough to allay investor fears. JPMorgan and Sterne Agee both upgraded the stock recently, and BB&T Capital initiated the stock at "Buy", confirming that perceptions are as strong as ever.

The rapid rises in stock price, the high multiple, and the positive perceptions provide evidence that we are now in far-from-equilibrium territory (Stage 4). I have, accordingly, established a speculative long position in the stock, both to maximize the profit during the remainder of the boom phase, and to alert me to the turning point. The turning point will likely be a significant news item that calls attention to the fact that 3D printing is still a niche market, and that rollout of the technology will take longer than expected. Alternatively, the allegations made by Grey Wolf could be valid, and an investigation could be opened. If either of these occur, I will reverse my position and begin shorting.

3D printing may yet revolutionize manufacturing. But boom-bust processes are normal in the introduction of revolutionary technologies. Gartner, an IT research firm, has used its "Hype Cycle" for years to describe emerging technologies:

The stages of the cycle are self-explanatory. Gartner stated earlier this year that 3D printing had already reached the peak of inflated expectations. I happen to disagree; I think the upward trend still has legs.

Source: 3D Systems Corporation: Implications Of Stock Price Reflexivity