INVESTING & VALUATION – AN INTRO
Information is gold to the investor, so much of the textexplains how the analyst identifies the appropriate informationand organizes it in a way to indicate intrinsic value. Organizing the accounting information—financial statementanalysis—is of particular importance. The analyst does not wantto be overwhelmed by the huge amount of information availableon firms and so looks for efficient ways of organizing theinformation, of reducing it to manageable proportions. Hedesires simple, straightforward schemes but is wary of ad hocschemes that are too simple. A simple (and popular) schemesays “buy firms with low P/E ratios and sell firms with highP/E ratios” for price relative to earnings is supposed to tell ushow cheap or expensive those earnings are. Selling Dell, with ahigh P/E in 2000, would have worked. But buying GeneralMotors or Ford, with low P/E ratios of 8.5 and 5.0,respectively, would not; Rather than comparing price toearnings, he compares price to value implied by the completeset of information. Traders in securities are not alone in valuinginvestments. Within firms, managers daily make investmentdecisions. They too must ask whether the value of theinvestment is greater than its cost. And they too, as we willsee, must forecast payoffs to ascertain this value.
What are Bubbles?
Much is at stake in valuing securities correctly. Trillions ofdollars were invested in stock markets around the world in the 1990s. By the end of thedecade, nearly 50 percent of adults in the United States held equity shares, either directly orthrough retirement accounts. In the United Kingdom, this figure was 25 percent, inGermany, 15 percent, and in France, 13 percent. These numbers were up considerablyfrom 10 years earlier. Stock markets across Asia and the Pacific started becoming moreactive than ever before. Firms in Europe and Asia that oncewent to banks for capital began raising funds through publicstock markets. An equity culture was emerging where firmstraded more and more with individual equity investors ortheir intermediaries. Unfortunately, the growing equity culturewas not matched with a growing understanding of how to value stocks. The experiencerepeated that of a decade earlier in Japan. Twelve years laterin 2001, the Nikkei 225 fell below 10,000 for a loss of over 75percent from the 1989 high. By 2005, the index had recoveredto only 11,800. The stock prices of the 1980s were a bubble,and the bubble burst. The repercussions in Japan werelong-term. By mid-2002, the index was below 1,400, down 75percent from the high, and was still only at 1,500 in 2008.
The S&P 500 Index was down 45 percent and the LondonFTSE 100 and the Euro-top 300 had lost more than 40percent. Again, a bubble had burst, leaving investors to wonderhow long the long run would be. As early as in January 2000,just before the bursting of the bubble, Alan Greenspan,chairman of the U.S. Federal Reserve Bank, was concerned.
What is so intriguing is that this type of behavior hascharacterized human interaction with little appreciable differenceover the generations. These stocks were part of the “NiftyFifty” stocks, deemed a “must buy,” that included Coca-Cola,Johnson & Johnson, and McDonald’s Corporation. The bubbledid burst. The S&P 500 P/E ratio declined from 18.3 in 1972 to 7.7 by 1974. TheFT 30-share index in London (prior to the days of the FTSE 100) dropped from 543 inMay 1972 to 146 in January 1975.
Stock market bubbles damage economies. Retirement savingsare lost and a pension crisis develops. Indeed, that was the fear in the market crashof 2008. Bubble, bubble, toil and trouble.
Working Principles of a Bubble
Bubbles work like a chain letter. You may have joined a chainletter as a teenager for fun (and not much consequence), or as an adult trying to getenough signatures to lobby for a good cause (hopefully with consequence). One letter writerwrites to a number of people, instructing each to send the letter on to a number of otherpeople with the same instruction.
If the letter involves money—each person in the chain is paidby those joining the chain—the scheme is sometimes referred toas a Ponzi scheme or a pyramid scheme. A few that are earlyin the chain make considerable money, but most participantsare left with nothing.
In a bubble, investors behave as if they are joining a chainletter. Each person believes that he will benefit from more people joining the chain, bytheir buying the book stock and pushing the price up. Whatgoes up must keep on going up. Indeed, this happens whenspeculation feeds on itself as the chain letter is passed along.
The complete opposite or reverse of this mechanism is alsovery much possible. During the mid-1970s, in a period ofgeneral pessimism amid oil price shocks, the S&P 500 P/E ratio fell below 7 and its price-to-book ratiofell below 1. At the time of writing (December 2008), during a severe credit crisis followingthe crash of a real estate bubble, equity prices fell significantly. Premium Wall Streetinvestment banks like Bear Stearns, Merrill Lynch, and Lehman Brothers disappeared. TheU.S. government bailed out Fannie Mae and Freddie Mac, the mortgage companies, andorchestrated a huge bailout of toxic assets help by financial institutions. As a consequence,investors feared a prolonged depressed market. (With you in real time, what subsequently happened?)
Analysts During the Bubble
As the renowned fundamental investor Warren Buffett observed,the boom in technology and the so called “Internet stocks” getting prominence in thelate 90’s was a chain letter, and the investment bankers beingthe “eager postmen.” He might well have added sell-sideanalysts (who recommend stocks to retail investors), some ofwhom worked with their investment banking colleagues to pushstocks at high prices to investors. During the bubble, analystswere recommending buy, buy, buy.
Only after the NASDAQ index dropped 50 percent did analystsbegin to issue sell recommendations. This is not very helpful.
One would think that, with such a drop in price,recommendations would tend to change from sell to buy ratherthan the other way around.
To be fair to analysts, it is difficult to go against the tide ofspeculation. The nature of a bubble is for prices to keep rising.
So, making a sell call may be foolish in the short run. Analystsare afraid to buck the trend. If they turn out to be wrongwhen the herd is right, they look bad. If they and the herdare wrong together, they are not penalized as much. But thereare big benefits for the star analyst who makes the correct callwhen the herd is wrong.
The issue calls into question what analysts do. Do they writeequity research reports that develop a valuation for a company, or do they speculate onwhere the stock price will go based on crowd behavior? They might do either or both. However, they should always justify their position with good thinking. Unfortunately, duringthe 1990s bubble, many analysts promoted poor thinking. They fed the speculation.
Fundamental Analysis Anchors Investors
Fundamental analysis cuts through the poor thinking that promotes the chain letter. Speculation promotes momentum in stockprices, but fundamental analysts see gravity at work. Prices,they insist, must gravitate to fundamentals, and the investoranchored to fundamentals has the best prospect for the longrun.