concept vs. valuation: the newest version of a traditional conflict

valuation vs. concept

For the 30 years + that I’ve been watching the stock market, there’s always been a conflict between concept and valuation among equity investors.

The opposition has often been regarded as one between growth investors as aggressive advocates of “concept” and value investors as the conservative custodians of “valuation.”  To some degree that’s correct, although it’s only a first approximation.  Value investors readily concede that there are value “traps,” stocks that look cheap, but have little chance of going up.  Companies in dying industries or ones where change of control isn’t possible might be examples.  Similarly, growth investors (most of us, at least) recognize that not all high expectation, high valuation stocks will justify their current prices, much less appreciate even more.

Another way of framing the issue is to contrast a “big picture” thematic macroeconomic investment stance of the “concept” investor with the “nose to the grindstone” approach of the “valuation” investor who looks for cheap securities without regard to in what industry or country they may lie.

Both approaches, taken as the primary—or even the only–security selection tool, have their potential pitfalls.  The investor who uses his overall conceptual framework to guide the search for individual securities risks overlooking evidence that contradicts his theory that an analysis of company operations might turn up.  The balance sheet-income statement only investor risks not seeing the forest for the trees.

examples:  valuation usually trumps concept in the stock market

the Nifty Fifty

This early Seventies period is one of my favorites–because it was so bizarre–even though it precedes my own professional involvement with stocks by four or five years.  The “concept’ was that a small number of fast-growing companies, like National Lead (car batteries) or Xerox (big office copiers), deserved to trade at p/es approaching 100x current earnings–which was 9x or 10x the multiple of the average stock .  How so?–projecting, say, 20% earnings growth each year for the following twenty and discounting that flow of future profits back to the present at even a high discount rate would product a value astronomically higher than the current stock price.

At that time, people also thought GDP growth could only be driven by manufacturing, not services, and concluded from this that base metals had to be a growth industry.  In addition, most Americans had never heard of Canon or Ricoh or fax machines, which were just about to wreak havoc on the domestic copier industry.

The subsequent price collapse was horrific and took a decade to reach completion (so much for efficient markets).

the road to the airport (Narita)

This was one of the last waves of the property mania that engulfed Japan during the second half of the Eighties.  The “concept” here was that continuing strong economic growth in Japan (The UK is like a man of 60, the US is like a man of 50, Japan is like a man of thirty.  Which would you rather be?–was a typical late-Eighties comment in the Tokyo market) would make even industrial land in the Tokyo suburbs immensely more valuable than the market realized.  As a result, investors reasoned, the warehouse operators, cement companies and the like who owned such land should trade at 10x the p/e multiples their “normal” operations would warrant.

Then the Bank of Japan raised interest rates.

Most of these companies are nowhere near their 1989 highs more than twenty years later.

the Internet bubble

Where is AOL today?–publicly traded, yes, but a mere shadow of its 1999 self.

today’s novel situation

Past major conflicts between concept and valuation have had the former side arguing for higher stock prices and the latter for lower ones.  Not so today.  The opposite is true.  A recent Bloomberg article is a good illustration.

Previous cases have been primarily about the stock market, and only secondarily about other asset classes.  This one is principally about bonds, with the stock market more or less suffering collateral damage from the negative sentiment the concept engenders.

Valuation:  the S&P 500 is trading at about 13x 2010 earnings and yielding about 2%, with profits being revised up by the most in the past six years.

If we assume the world will continue to expand, possibly at a rather slow rate, in 2011, corporate profits will be higher and the market multiple based on next year’s earnings (the market typically begins to discount the following year’s profit prospects during the summer) correspondingly lower.

Equating the stock market price earnings multiple with the long government bond yield would produce a long bond of 7%+ if bonds did all the adjusting or a stock market p/e of 25+ if stocks did.

Concept: It’s the “new normal,” a picture espoused primarily (solely?) by bond managers.  The general idea is that world economies have been so badly damaged by the financial crisis that global economic growth will be minimal for many years to come.  Governments will inhibit rather than help recovery.

This is, perhaps not by coincidence, the only scenario I can envision where it makes sense to invest in bonds at today’s ultra-low interest rates.  That is, it’s the only scenario where bonds don’t lose money

This concept has a corollary, that the apparent attractiveness of world stock markets–the main alternative asset category to bonds–is chimerical.  As far as I can see, this corollary is simply an assertion, without any attempt to provide a reason, other than the general picture that economic malaise will spread like a virus and infect previously healthy sectors and regions.

I also suspect that the bond manager analysis of stocks is comes from a rookie’s misunderstanding of the relationship between the economy of a country and its stock market.  In the case of bonds, the relationship is very close.  In the case of stocks, however, the relationship depends heavily on what sectors of the economy are publicly listed and what international exposure listed companies have.  There’s no general rule.  In the US, for example, commercial real estate, housing and autos have almost no direct market presence.

my thoughts

I think this is the most important issue facing the stock market in the US–in the world, for that matter–today.

It’s more an issue about sentiment than anything else.  The fact that the negative side is being put forward by people who have no practical knowledge of stocks is irrelevant.  They may be ugly, too, but that doesn’t mean they’re wrong in what they say.  Their being right would be an accident, but they’d be right nonetheless.

Earnings are likely to come through as well as predicted, if not better.  Looking at matters very simply, the US economy has gone from having 95% of the workforce employed to having 90%.  That extra 5% is likely to remain unemployed for a long time, creating a severe social problem.  Nevertheless, that 5% was in the aggregate probably not the most productive part of the workforce.  So it likely contributed 2%-3% of the output in US GDP, and perhaps the same amount (at most) to the domestic profits of publicly listed companies.

In the aggregate, domestic profits are about half of the total for the S&P.  This would imply–negative sentiment aside–the newly unemployed would create a one-time, 1%-2% reduction in the level of S&P 500 earnings.  So I find it hard to believe that corporate profits won’t come through in a way that justifies higher stock prices, especially since companies are starting to restore wage and benefit cuts instituted during the recession.  Raises and promotions are beginning to occur as well, in addition to very limited new hiring.

If the S&P falters, then, it will more likely be due to concept than valuation.

It will be interesting to see how the stock and bond markets develop from here.  In the past, in my experience, concept has always overreached by extrapolating the status quo too far into the future.   It has always lost out to valuation.

On the other hand, this is the first time in my experience where valuation has argued plainly for higher prices and concept for lower ones.

In the past, you might observe, the camp militating for higher prices has always lost out  At first blush, this would seem to be a worry for stocks.  But my take is that the overreachers are the bond guys, who are arguing for stable or higher bond prices.  They’ll be the ones undone by valuation.

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