It is quite obvious that asset prices are, oftentimes, driven by investor emotions and sentiment, especially in the short term. It explains how cryptocurrencies, created as jokes and based on a dog meme with zero real-world utility, can appreciate by gazillion percentages and how companies whose businesses are in secular decline can still be valued at market capitalisations of tens of billions of dollars.
Tesla recently broke above the trillion-dollar market cap milestone, joining an elite grouping that comprises Apple, Microsoft Corp, Amazon.com and Alphabet. The thing is that its bonds are below investment grade, according to rating agencies Standard & Poor’s and Moody’s Investors Service, while debts for the other four companies are of the highest triple-A rating. It sure appears as though investors are irrational — but are they really?
We could point a finger at the foolishness of this generation, the YOLO Robinhood traders. But the reality is that such investor behaviour has persisted for far longer. British economist John Maynard Keynes explained this behaviour in his book The General Theory of Employment, Interest and Money, which was first published in 1936. He theorised that investors are in fact acting quite rationally — they are pricing stocks not based on what they think is the intrinsic value but what they think other people are thinking that other people are thinking. This concept is called the Keynesian beauty contest.
In other words, investors are trying to get the jump on the market by predicting what other investors predict others will find valuable — and acting on it first. For instance, Bitcoin recently hit fresh all-time record highs. There is no change in its underlying utility or scarcity or intrinsic value, which, incidentally, we still think is near zero. Instead, this latest rally comes ahead of the launch of the much-hyped bitcoin futures exchange-traded fund. It made sense for some investors — because they anticipate prices will go even higher with the availability of a safer, exchange-traded regulated derivative instrument that would broaden the cryptocurrency’s appeal and investor base.
As we have said numerous times, the stock market is a market for individual stocks. Prices are determined by demand and supply. A key driver for demand is the perception of value, which is, in turn, shaped by expectations of the collective preferences. Since preferences are dynamic, each investor is constantly reassessing what others are thinking, therefore resulting in uncertainties and short-term price volatility.
Beauty may be in the eye of the beholder, but stocks have absolute values. The intrinsic value of a stock is its future cash flow discounted for risks and inflation — derived based only on the characteristics of the business or underlying asset. It does not change with the perception or expectations of other investors.
Greater minds than ours have debated the philosophical question of absolutism versus relativism for centuries. The argument for relativism in the broader world has great merits. Standards, morals, values, ethics, principles and such should be viewed in the context of time, place and people. The relativist approach allows us the freedom in beliefs, views, speech and acceptance that there is diversity in culture, in people and so on. That said, we do not believe in absolute relativism, where there is no absolute truth and what is intrinsically right or wrong. Rather, we think there is absolutism within relativism. There have to be anchors of what is intrinsically right or wrong in each period of time as knowledge grows and society evolves.
When it comes to value investing — that is, investing for the long term and not speculating — the absolutism approach must prevail. The basis of value investing is in picking stocks that are priced below or, at the very least, near intrinsic values. This is not to say we should not compare a particular stock against its competitors or other competing investable assets. For instance, we compare the prevailing yields on stocks and fixed income instruments such as bonds or bank deposits to determine portfolio allocation. The risks — and perception of risks — of different assets and businesses are relative. We may also compare between stocks in terms of non-financial factors, such as in the consideration for environmental, social and governance (ESG).
What we should not do is value a stock based on what its peers/competitors are worth. That said, the use of relative valuations is commonplace. Analysts use a plethora of ratios, multiples and other benchmarks of peer/competitor companies and industry averages to determine the worth of a stock. We have explained before why price-to-earnings or price-to-sales multiples are useless in themselves in determining whether a stock is under- or overvalued. Such relativism as an investing strategy may be easy to understand — and profitable, if you are lucky. In reality, however, it is little more than punting or gambling, if prices are far disassociated from the intrinsic values.
Along the same vein, investors should beware of plastic unicorns. What do we mean? The rapid growth of digital tech companies and even higher returns for well-known names such as Apple, Alphabet, Alibaba Group Holding and SEA have spurred many in the search for the next unicorn. As with all things, when people are intent on finding certain things — be it unicorns or wine or truffles — it will inevitably lead to pretenders or, worse, outright fakes.
For example, we hear of enterprising businessmen listing in Australia to achieve “unicorn” status — achievable simply because the average valuation for tech stocks listed in the country (108 times forward earnings) is significantly higher than that in the US (32 times forward earnings). We are inclined to call these companies “plastic unicorns” — they are based on stretchable valuations, owing to a combination of factors such as thin trading volumes, low free float of shares and less research coverage (see Table). These valuations are not real. Relative value is not intrinsic value — the intrinsic value (underlying fundamentals) of a stock is exactly the same whether the company is listed in Australia, the US or, for that matter, anywhere in the world.
The Global Portfolio gained 0.5% for the week ended Nov 2. Leading the gainers were ServiceNow (+3.3%), Microsoft (+3.1%) and Wells Fargo & Co (+2.5%) while shares in BP (-4.5%), Amazon. com (-2.4%) and PayPal Holdings (-2.3%) ended in the red. Last week’s gains lifted total returns since inception to 68.2%. This portfolio is outperforming the benchmark MSCI World Net Return Index, which is up 62.4% over the same period.
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