more on concept vs. valuation

All successful stock investing is based on the idea that we know more than the consensus. If we look at the stock market as a closed system, there are two aspects to this:

–the concept, i.e., our expectations for a stock we think is priced too low, and

–valuation, today’s price of the stock, which reflects the current (uninformed, we hope) market opinion of its prospects.

Professional investors generally employ one of two approaches to finding undervalued stocks. Growth stock investors seek out companies that they think are expanding earnings faster and/or for longer than the market now realizes. They figure this mistaken analysis by the consensus will become apparent–and the stock will rise–as the company consistently posts surprisingly strong (vs. the consensus view, anyway) results. Value investors, in contrast, look for companies that are hitting rock bottom. They think a target company has valuable assets that a bungling current management is not using to their fullest potential and that some internal (the board of directors, say) or external (a potential acquirer) force will change this–leading to a much higher stock price.

Another way of looking at this is that value investors know more about what they own and less about when change will happen. Growth investors, in contrast, know with certainty when earnings will be reported but less about whether their expectations will be fulfilled or not.

Unfortunately, life isn’t that simple. The stock market isn’t a closed system. Substitute investments, in this case bonds, also play a role.

the question of substitutes

The iron law of microeconomics is that price is determined by the availability of substitutes. In the case of liquid investments, the choices are: stocks, bonds and cash. Because of this, changes in interest rates, which have a direct effect on the latter two, also have an immediate effect on the valuation of the first.

This morning the 10-year Treasury is yielding 1.37%. According to academic finance–in this case, the best thinking we have–we can equate the interest yield on bonds with the earnings yield (1/PE) on stocks. The main difference between the two measures, as I see it, is that interest payments go into the bondholder’s pockets, while the shareholder’s portion of company earnings remains in the control of management.

If we thought that yields would stay at 1.37%, the academic equation would imply a market PE of 70x or so. But we know that Treasury yields are a emergency lows today. Nominal yields in closer to “normal” times, which the stock market is already anticipating, I think, would likely be somewhere between 2.5% (implying a 40X PE on the S&P) and 3.0% (implying 33x) . In a robust recovery, even 3.5% (28x) might be possible. The current PE of the S&P 500, based on trailing earnings, is about 38x. This means that in all but the most tame recovery and yield scenario, the PE multiple on the S&P would be subject to substantial compression.

In a robust economy, the kind that would naturally lead yields higher, idle or unused assets would arguably have a greater value than in a somnolent one. So compression of PEs would likely have little effect on price. Stocks whose attraction is accelerating growth, however, i.e., which are valued on their earnings, would presumably bear the brunt of the market PE multiple compression. At least, they always have in the past. For them, investors have to consider the tradeoff between soaring earnings and rising interest rates.

Tomorrow, ETSY as an example.

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