Valuation Never Tells The Entire Story
Human emotions are often much more important
Cheap Doesn’t Mean Buy
To suppose that the value of a common stock is determined purely by a corporation's earnings discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defense of Joseph Stalin and believed Orson Welles when he told them over the radio that the Martians had landed. - Jim Gant
While reading Morgan Housel’s terrific new book titled “Same as Ever”, this quote captured my attention, and I believe offers a very valuable lesson to anyone, admittedly myself sometimes, who gets caught up in a spreadsheet that says a certain stock is a “good deal”.
Numbers rarely, if ever, tell the whole story. I have two examples of this, one present and one in the past. The “Chinese Amazon” Alibaba currently trades at 7x next year’s earnings, and has traded at these cheap valuations for some time now. Value investors have continued buying this stock due to what they believe is a discounted valuation, but have yet to be rewarded for this. Year-to-date the stock is down 20%, and down 21% from its IPO in 2014. Yet since the IPO, earnings have only grown. So how is it that Alibaba has grown earnings and improved their fundamentals, but this is not at all reflected in the stock price?
Investors worry about geopolitical issues and relations with the U.S. and China. Many people do not want the risk of owning Alibaba because China does not have a free economy. This is not an issue unique to Alibaba, and is faced by many Chinese stocks that trade in the US. The fundamentals don’t matter, but the geopolitical story does. Investors do not have the confidence that Alibaba will be able to overcome the weight of the Chinese government.
The second story is one that Morgan used in his book, and involved Lehman Brothers. On September 10, 2008, Lehman’s tier 1 capital ratio, which measures a bank’s ability to handle losses, was 11.7, which was higher than the previous quarter, year, and industry competitors Goldman Sachs and Bank of America. On September 13, 2008 Lehman Brothers was bankrupt.
If the bank’s fundamentals were strong, stronger than competitors who ended up surviving the banking crisis, why did Lehman fail? That question in itself is a loaded question, but the basic answer is a loss of confidence by investors and creditors. Money flowed out of Lehman, and the bank failed.
The lesson here is that valuation and fundamentals never tell the entire story. It is borderline reckless to buy a stock simply because it has a cheap valuation. Often times stocks trade at cheap valuations for deserved and legitimate reasons. Maybe the business the company operates in is being disrupted, and the entire business model is at risk (Ford and GM could be an example). Maybe there are geopolitical concerns surrounding where the company is based (Alibaba). Maybe there are litigation concerns surrounding the company and the outcomes could be drastically unfavorable (3M). In each case, a cheap valuation does not necessarily mean the stock is a “good deal”.
Emotions often drive stock prices for long periods of time, and in both directions. You can use this to your advantage, or let it be your downfall.
I’ll leave you with a quote by Charlie Munger, who we sadly lost this week, which I believe makes the point I want to make far better than I ever could:
A great business at a fair price is superior to a fair business at a great price.