Thursday, March 25, 1999
Once upon a time, value meant something to some investors, columnists, and commentators. "But it doesn't mean anything anymore," they now moan. Perhaps we can get a pharmaceutical company to develop an acute pain-management lollipop for the "deep value" investors because they're beginning to sound like a dog that's just been hit by a car. They may have to wait awhile for the next recession or interest rate spike.
When I put the phrase "value investors" in quotation marks, I'm talking about the people who haven't bought any stock since 1991, 1993, or 1995, and who think all great companies are ridiculously overpriced. The reason I'm so harsh about it is because I consider a focus on the market as a whole, rather than on individual companies and securities, to be an amateur exercise for investors. For traders, that's their job and I don't begrudge it. The skeptic asks why things are. The "value investor" wails and cries instead of spending time actually digging for value. Unless you've got tens of billions of dollars to invest and can't find companies that have the size requisite for effective investment, there's really no excuse for this.
Watching CNBC's Squawk Box this morning, one of the guests was talking about valuation parameters that have lasted for the last 56 years. Just as a study of religion or architecture will suffer without looking at contemporaneous culture, politics, and the general milieu of a certain time, a study of valuation over the last 50 years isn't going to tell you everything you want to know about valuation today. To wit, anyone who treats either today or 1974, 1929 or 1987, and 1933 or 1981 as the norms do so at their own peril. Of course, five sigma events happen, but extrapolating reality from them and wallpapering the world with that view is going to turn your brain into mush.
In the 20th century, major recessions and wars have been the exceptions, not the rule. It's the damaging exceptions, however, that give rise to both damaged perceptions of the world and to great advances of scholarship. Ben Graham's book Security Analysis was the product of the damaging exception of the market's behavior from the late 1920s into the first three years of the 1930s. The damaging exception of the Depression gave rise to GATT and Bretton Woods at the close of World War II. The rise of codified free cash flow analysis in the 1970s was due in part, I believe, to the damaging exception of the Nifty 50 crash. And it was the damaging exception of a severe spike in the price of money and oil (an inflation-adjusted anomaly over the history of oil) in 1973-1974 that has informed the entire traumatized worldview of a number of "value" investors today.
Not that I'm saying there is no danger in the market today. I couldn't agree more with an investor like David Dreman: Value is highly important. But I couldn't disagree more with the implications of Dreman's columns. While we would all like to have the great companies priced at levels that offer super-normal returns on investment, that's not how it goes in a low-inflation, high-growth environment with tons of long-term global opportunities. Just because there are a lot of companies that are carrying very high valuations doesn't mean that value does not exist today, and it's not just in companies that have been priced (by an efficient market) at a fraction of book value or revenues.
One must understand that valuation is a context dependent exercise, not one where absolute norms can be derived by taking the simple arithmetic means of past history. In the introduction to his Investment Valuation, New York University finance professor Aswath Damodaran lays out six myths of valuation. In my role as a communicator of useful information, as opposed to being only a progenitor of information, I pass these along to you, with comments that may or may not agree with Damodaran's.
Myth 1: Since valuation models are quantitative, valuation is objective.
I could make a series out of that one. If your investment banker comes to you and pitches you on taking your two-year-old money losing company public, and they put a price on your company based on price/sales and cash flow multiples of five publicly traded peers, it doesn't mean that reflects the intrinsic value of your company. It's a subjective data set.
It also means that I can make up whatever I want to in a spreadsheet. For me, the process of valuing a company isn't always determined by making my best judgment as to what I think the company can do over 20 years. Even if you run your own company and know it like the back of your hand, that can be very difficult to impossible. But you can reverse-engineer the expectations that a subjective market has baked into the current price of a company and then make a decision based on that process of discovery. Even then, that's a subjective judgment, but I believe part of Damodaran's point is that you can't get away from subjectivity in valuing a company.
Only if you have a crystal ball and can see cash flows in the future can you make a truly objective valuation that only requires you to plug in your own discount rate to arrive at a buy point today. Finally, this also means that investment valuation is as much art as it is science. For instance, the national income accounting equation that the Office of Management and Budget and the Congressional Budget Office uses is as much the product of political and philosophical biases as it is the result of very complex algorithms. You have to know that economics is a social science to understand it, just as you have to know that the process of valuation is a set of estimates based on certain facts.
Myth 2: A well-researched and well-done valuation is timeless.
The milieu affecting the value of a company can change every day. The world is not static and neither are securities prices. When the term "efficient market" is used, it means the market is pretty good at reflecting what is known and, as a complex adaptive system that works as mysteriously as an ecosystem, what is not generally known. "Efficient market" should not mean that no one can outperform the market or that you even need to be Warren Buffett to do so. Again, that's my own observation, not Damodaran's.
Myth 3: A good valuation provides a precise estimate of value.
First I'll say that intrinsic value can mean two things to two people, depending upon your required rate of return. If you have a five-year holding period in mind, Coca-Cola at $70 might not return any more than a five-year corporate bond, given that the market treats the company's payback potential as inevitable as the federal government's securities. This also means that you have to realize that you're not going to get every element of a valuation scheme right, no matter how good your skill at valuing companies. You can find out you don't know a darn thing about the dynamics of a company, and you can also be pleasantly surprised if you underestimate the quality of a company. But you can also overestimate the quality of a company in its ability to create the cash flows necessary to produce a satisfactory return on your capital. Also see Ben Graham's Security Analysis (1934 edition and 2nd ed. if you can find it), The Intelligent Investor, and the forthcoming The Rediscovered Benjamin Graham.
Myth 4: The more quantitative a model, the better the valuation.
Garbage in, garbage out, the saying goes. Better to be approximately right about something than precisely wrong, John M. Keynes observed.
Myth 5: The market is generally wrong.
Respect the power of the market. Sometimes you're just flat wrong. As for the value nuts out there today, the market is going to strive to discount equities such that returns on a longer holding period match the historical rate of return on equities. It would be nice to pick up Coca-Cola at 15 times earnings, but it's not going to happen unless California drops off the edge of the continent or someone nukes Manhattan.
Myth 6: The product of valuation (i.e., the value) is what matters; the process of valuation is not important.
If you construct a valuation model, it forces you to think about the business. Give me one investor who has looked at a bunch of canned data on a number of companies and give me an investor who has constructed the data him or herself and I'll say definitely that the second investor is better informed.
The market forces a discipline on investors, and that is to think about companies underlying the indices. The more you think about the index and the less you think about the underlying companies, the less you're going to understand what counts. If you spend a lot of time looking at companies and your daily conclusion is that things are just not cheap, that's one thing. But if you keep on checking in on a few companies and see that they're not cheap every time you look, well, you might have to wait around for a while. Value exists out there -- you just have to do some digging. Even then, the process of value discovery is a subjective one and everyone is prone to human failings, but the process makes you stronger intellectually and temperamentally.
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