a market of companies…

..as opposed to a market of themes (should I say dreams?).

Post Benjamin Graham during the Great Depression, the first big academic conceptualization of how to value equities was the Gordon Brown Dividend Discount model of the 1950s. The basic idea is that the true worth of a share of company stock is the sum of all its future dividend payments discounted back to the present using the current interest rate.

In reality–and as is the case with most academic stock market theories–this is not a particularly helpful practical rule. What it does do that’s valuable is to try to quantify the inverse relationship that exists between equity values and interest rates. In common sense terms, the higher rates go, the less a future stream of dividend payments is worth; the lower rates are, the bigger the value of that future payment stream.

When interest rates are at or near zero, the Gordon conceptualization suggests the income stream should be worth infinity. Put a different way, no price is too high to pay for stocks in general. And for those in particular whose near-term prospects are the most nebulous–meaning “story” or “dream” stocks–they may actually get to infinity faster than their more staid counterparts.

In short, interest rates near zero cause all sorts of crazy behavior. Other than the pandemic period, the only time I’ve experienced this market phenomenon was in the Japanese market in the late 1980s.

We’re now in the post-party hangover period.

I’m willing to believe that interest rates are now as high as they’re likely to go, and if not, we’re close enough to the peak that rising interest rates is no longer a major worry. We can also see the severe damage done to companies like Silicon Valley Bank or WeWork that got carried away and did crazy things during the euphoria of zero rates that have come back to haunt them as rates have risen.

At the same time, it seems to me that there’s a very human impulse for managements to try to disguise smaller wounds that they have inflicted on themselves during the past few years. Maybe it’s a lot of excess inventory, or variable-rate debt taken out in the belief that rates would stay low for longer, or over-aggressive expansion (think: Elon Musk and X), or lots of now-dubious receivables.

Anyway, I think we’ve got to go through our holding, company by company, looking for warts. in addition, we’ve also got to question, as world trade returns to more normal–and as more countries follow the US in erecting trade barriers–whether our holdings are in a stronger or weaker position today than they had pre-pandemic.

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