asset value vs. earnings momentum

This is a very complex topic that I’m deliberately and shamelessly simplifying.

A reasonable way to think about the asset value of a publicly traded company is its liquidation value–that is, what a savvy buyer would pay for the company if it were being offered for sale. If we were confident in the accuracy of the company’s financial reporting books, the appropriate reference figure would be shareholders’ equity (total company assets – total liabilities).

This has very little to do with current earnings.

During the Great Depression of the 1930s, a period of great uncertainty–and one in which the accounts of Silicon Valley Bank would have been astoundingly good revelations of its financial position, Benjamin Graham advocated that investors disregard long-term assets like plant and equipment entirely and pay only for a company’s net working capital. That’s cash + receivables + inventories – payables and all debt.

Warren Buffett added importantly to this discussion of value with his observation that in the post-WWII world, many companies had developed strong brand names (Coca Cola being a prime example) and distribution networks but these very valuable intangible assets only appeared in the company accounts as subtractions of value (expenses). In today’s world, the same is true of proprietary software development.

If you believe this, as I do, then there’s a price where you’d be an eager buyer of a stock even though current earnings are in a slump.

In fact, during typical cyclical downturns, the stock market has tended to bottom around half a year before earnings begin to rebound from their cyclical lows. To some degree, this is anticipation of better times ahead, but it’s mostly based on asset values.

A cartoonish (yet possibly correct) version of this would be: the US economy will begin to rebound early in 2024; therefore, the market is either bottoming now or will be doing so within the next month or two. This is too simple. We’re now in a world of index funds and trading bots trained to be rabid disciples of earnings momentum. So there may not be that many entities either doing bottom fishing in a sophisticated way, or on the sidelines waiting for the right opportunity. In addition, we’re also dealing with the hangover from the wild party that zero interest rates induced. And, given the parlous state of national infrastructure and education, and the country’s strong anti-immigration bias, recovery is unlikely (I think) to be a rip-roaring affair.

Still, I think it’s important to imagine what positive earnings momentum might look like and to begin sifting through the rubble for areas of possible growth.

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