Thursday, July 18, 2002

Stock Market Heresy Pt. II Send this entry to: Spurl Ma.gnolia Digg Newsvine Reddit

Stock Market Heresy Pt. II Okay, I'll bite. Here's my (rambling, and yes, oversimplified) response to Joel's earlier assertion that market value isn't directly tied to intrinsic value and Razib's assertion that so-called stock market experts are talking out of their asses when they imply that they actually know what's going to happen tomorrow or ten years from now. For the most part, i'd say you're both right. Intrinsic value is loosely based on the cost basis of the company's existing assets and the net present value (NPV) of the company's future cash flows (FCF), which can be extrapolated from historical growth and discount rates. The cost basis variable is fairly objective. What did the company pay for the equipment, property, etc. ? The NPV of FCF is more subjective. Averaging historical growth rates and historical costs of capital to get the value of FCF is the conventional way to do it, but there are exceptions to the rule. If, for example, the company is pursuing an aggressive merger and acquisition schedule, and hasn't done so in the past, it's reasonable to assume that growth rates in the future would exceed historical rates. Market value = what the market is willing to pay at any given point in time. Market value reflects the market's assumptions about the subjective variables that contribute to intrinsic value (i.e., growth rates, cost of capital.) Those assumptions are often wrong. A GNXP reader called me a 'sniveling Marxist' a few weeks ago (heh - he obviously hasn't read my personal blog) because I implied that the market wasn't always right. In the long run, the market generally appears to conform to basic economic tenets, which would suggest that at least in the abstract sense my critic is right. (It should be noted, however, that given the relatively short history of U.S. capital markets, it's a little difficult to test. How many economic cycles constitute a valid sample size?) In the short run, however, the market is wrong on a regular basis, and what's more, people *expect* the market to be wrong. they also expect eventual "market corrections" when this happens. People begin to feel that the market is overvalued. "Feel" being the operative word. No one can predict the future. One would think that fortune telling statutes would prevent analysts from setting price targets on stocks, but alas, no... The value of future cash flows is really the *perceived* value of future cash flows, which is, by definition, subjective. The cost basis of hard assets and resale value upon breakup are generally not. You want to find out the resale value for something? Go try to sell it. (On this one point, I sort of disagree with Joel when he insinuates that stock ownership is an illegitimate proxy for actual ownership of a company.) You see the ownership aspect in bankruptcy situations. Having actually watched investors trade in stock certificates for office furniture and brand new Cisco routers, i can attest to the fact that there is some direct connection to company ownership, at least in terms of existing hard assets, if only because bankruptcy law formally and directly binds the two. (If you wanted to trade in your one share of MSFT for, say, a used Aeron chair upon the Evil Empire's liquidation, assuming you have a senior security, you *could* technically do it, although the cost of conversion would probably exceed the value of said chair and it wouldn't make rational sense to do pursue it.) The issue is that if the *only* potential value in owning the stock is the breakup value of the company, no one would invest. There would be no upside. The upside is the related to the perceived value of future cash flows, and joel's right, you can't directly own something that doesn't' exist yet. (Argh. Will perhaps find a better way to word/explain that later...) The perceived upside changes as investor expectations change (a result of both rational and irrational assumptions and subsequent behavior) and the price conforms to the perceived upside. Because perception isn't always reality, Joel's largely right. When, however, someone asserts that X market is "40% undervalued", they're really saying that "X" market is 40% undervalued relative to fairly recent historical patterns of *perceived* value. (These change over long periods of time. Certain industries, for example, tolerate much higher P/Es than they did two or three decades ago.) Small caps tend to illustrate the perception =/= reality phenomenon very well. Stupid investor psychology run amok, really. A large sale in a stock that's relatively illiquid (i.e., most small caps) can create a panic in which other shareholders exit the investment on the basis that the large seller must know something they don't, and a large buy may produce the same results. (Another example of the greater fool theory Joel mentioned.) The large sale may have occurred for no other reason than because the shareholder wants to buy a new house and needs cash. It may have nothing to do with the company. The stock price still goes down. In my experience, most "stock market experts" - the ones with whom i interact, anyway - don't start with economics to make their so-called 'predictions." They start with trying to predict investor sentiment and use economic theory to justify those predictions. (The running half-joke when I was doing a lot of VC work was that you "picked a valuation and backed the assumptions into it." Same concept. ) Some of them don't even do it consciously. You only realize it when you press them to flesh out the rationale behind their argument, and they start at the wrong end. When I make buy recommendations (buy-side so that rarely happens), I almost never put a hard price target on a stock, and try to avoid quantifying upside within narrow bands. (One of the advantages of being an independent analyst is that there's no pressure to be more exacting than necessary or practical.) I usually just assess risk and try to identify the factors that would prevent an otherwise healthy, growing company from experiencing some level of price appreciation in the stock. Then I assign some level of probability to the likelihood that those things are going to happen. You try to make rational, objective, and conservative assumptions, but at the end of the day, it's still subjective. you're still just rolling the dice based on what you think are legitimate reasons to believe that the odds are in your favor. Why do people listen to stock market experts? Ideally because they're better at assessing risks, but i'll certainly admit that that's generally not what happens. Most people try to use stock market experts to predict the future, something which *no* expert, no matter how good, is capable of doing. Consumers also tend to listen because they don't understand enough about how the market works to do their own homework - or frankly, because they're too lazy to do their own homework. Keep in mind that equity investments were considered highly speculative in the not too distant past. Modern equity markets and securities regulations haven't really caught up to consumer demand and participation. Professional investors that *do* understand markets may listen to stock market experts out of fear that these experts have become market forces in their own right. A word from the right "expert" can cause a major shift in investor psychology. Rather than interpreting market forces, the experts create them.

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