A short history of valuing stocks

{"text":[[{"start":5.24,"text":"When I first started in stockbroking in April 1984 there were four of us in the research department — though one always seemed to be at lunch."}],[{"start":13.88,"text":"In the corner stood a computer with a large cathode ray tube monitor and a similarly chunky book on how to use it. I may have been the first to turn it on."}],[{"start":22.84,"text":"I eventually managed to program it to come up with sensible valuations for debentures issued by investment trusts, based on expected dividends and adjusted for inflation expectations. It meant our valuations were a penny or halfpenny better than the jobbers’ prices — an edge that enriched my colleagues long after I’d left."}],[{"start":41.72,"text":"It was a promising start, but a career spanning 40 years has seen plenty of crises and challenges too. US markets look as stretched as at almost any time in history — by some measures the only time they’ve peaked higher was just before the 1999-2000 dotcom bubble. Perhaps unsurprisingly, far more people are asking me today about investment risk than opportunity."}],[{"start":64.68,"text":"Can the history of investing and the study of valuation discipline help us avoid losses in the next crisis?"}],[{"start":null,"text":"

"}],[{"start":71.12,"text":"Inevitably, the story starts with the Wall Street Crash."}],[{"start":74.86,"text":"“Early in 1928, the nature of the boom changed. The mass escape into make-believe . . .  started in earnest,” wrote JK Galbraith."}],[{"start":83.16,"text":"In the months that followed, share prices plunged more than 85 per cent."}],[{"start":87.76,"text":"Before 1929, equities were mainly valued either on their dividend yield (the dividend payments divided by the share price) or assets stated in the balance sheet."}],[{"start":97.56,"text":"Investors liked companies that paid higher dividends than government bonds or consols (a perpetual government bond that paid a fixed regular interest payment forever with the original principal never repaid). Sporting types might buy shares in a railway or a mine somewhere exciting as a gamble. But by 1928 investors were borrowing money from the bank to gamble on the markets."}],[{"start":119.72,"text":"In 1934, two teachers at Columbia Business School, Benjamin Graham and David Dodd, published Security Analysis, summarising the lessons to be learnt. Their book — the bible of “value investing” — has influenced investment thinking for decades."}],[{"start":134.2,"text":"They were scathing about the lack of genuine equity analysis in Wall Street before 1929 (though, to be fair, companies only had to file audited financial statements after the Securities Exchange Act of 1934, so I’m unsure how reliable the data was back then)."}],[{"start":152.4,"text":"Graham and Dodd wrote: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” They particularly noted how investors assumed that recent growth trends would go on forever."}],[{"start":null,"text":""}],[{"start":170.8,"text":"Graham and Dodd’s recommended valuation tools evolved over time. In 1958, Phil Fisher published Common Stocks and Uncommon Profits, seen as the birth of growth investing."}],[{"start":182.6,"text":"Rather than look for undervalued companies, Fisher sought companies with growth potential, usually arising from competitive advantage and driven by their investment in research and development."}],[{"start":193.52,"text":"Maybe it influenced Graham. By the 1960s, he was proposing a valuation heuristic that encompassed a recognition that if a company’s earnings were growing then equity investors should be prepared to pay more. He suggested — with footnoted caveats — that the value of a share should be the company’s earnings multiplied by 8.5 and then by twice the expected annual growth rate."}],[{"start":216.68,"text":"The dangerous word there is “expected”! The “Nifty Fifty” bubble of 1972-73 saw many big US shares trading on 50 times P/E multiples — far more than the wider market."}],[{"start":230.2,"text":"Graham’s formula had been a significant advance, but his work made little reference to government bond yields — nor to inflation, which affects those yields. Shares look less attractive when bond yields rise and this can weigh on equities. The oil crisis and massive inflation of the 1970s highlighted the problem of Graham’s omission and burst the Nifty Fifty bubble."}],[{"start":252.68,"text":"With inflation reaching double figures — peaking at 26.9 per cent in the UK in 1975 — recession struck. Equity markets crashed between May 1972 and December 1974 — by more than 40 per cent in the US and by 73 per cent in the UK."}],[{"start":271.12,"text":"Warren Buffett was a student of Graham’s in the 1950s. He and Charlie Munger used the insurance funds at Berkshire Hathaway to become very wealthy, which naturally made many interested in their valuation approach. Buffett and Munger’s aphorisms have become investment lore for generations of investment professionals."}],[{"start":289.28,"text":"One of Munger’s most-quoted lines is: “A great business at a fair price is superior to a fair business at a great price.”"}],[{"start":297.48,"text":"Over the years, technology has evolved to help us judge what is a fair or a great price."}],[{"start":303.04,"text":"My second year in the City saw me join stockbroker Phillips & Drew and a group that had identified the balance-sheet approach to equity valuation as its forte. We were helped by a new computer program called “Excel”."}],[{"start":315.58,"text":"Asset values had risen with inflation from the 1970s. Share prices had not. So asset-heavy companies offered rich pickings. Excel helped us identify the best. A fair number of UK equities were selling for less than half their book value. (Today it would typically be around twice book value.)"}],[{"start":333.32,"text":"A decade later, Warren Buffett would call this ‘cigar-butt’ investing — akin to taking the last tobacco from old cigar ends left on the street. You then let the share price bump up and sell for a quick profit. Buffett used it to great success in his early days."}],[{"start":348.36,"text":"We weren’t alone in using balance-sheet research to highlight deep-value opportunities. Lord Hanson famously bought the Imperial Group in 1986 for £2.5bn, quickly disposing of several non-core holdings and recouping all that purchase price. Over the next seven years the remaining business soared in value to £2bn."}],[{"start":368.64,"text":"But this approach — which is often what people mean when they refer to “value investing” — only works in extraordinary markets. It’s why charts plotting the performance of so-called “value stocks” show them declining (outside of Japan) for much of the past 40 years."}],[{"start":383.24,"text":"The lesson is: never buy a fair company — and certainly not a bad one — just because it’s on 1.5 times book in a market on two times book. In those markets you need to use growth techniques (or just leave your money in the bank and wait for a crash to buy value again)."}],[{"start":null,"text":""}],[{"start":397.9,"text":"By the late 1980s most of these bargains were gone. There was a new game in town — technology, including something called the “internet”. Excel sheets allowed models to be built with cash flows far into the future discounted back (remember cash in the hand is worth more than cash in ten years’ time) to give what is known as a “discounted cash flow” valuation."}],[{"start":420.86,"text":"Excel allowed recent growth rates to be extended into the future through a simple copy and paste — so simple that it ended up being done without common sense checks on the unrealistic extrapolations. There was also plentiful room in the spreadsheet to tweak the odd parameter to come up with whatever valuation you fancied to justify your gut instinct to buy. Hence the technology bubble and tech wreck of 2000."}],[{"start":445.48,"text":"One of the simplest measures of value is the price/earnings (P/E) ratio — the ratio of a share price to earnings per share. It’s too simplistic on its own, but can be a helpful gauge of excess. Those who used their common sense in 2000 could see that the earnings multiples were excessive. Vodafone shares were on a P/E of more than 70; the share price today is still less than a third of what it was then. It was painful watching prices of shares I was too disciplined to own continue to soar; less so when they dropped."}],[{"start":477.4,"text":"The focus on growth valuation had another vulnerability. Goodhart’s Law says: “When a measure becomes a target, it ceases to be a good measure.” Bosses realised that many valuation techniques focused on earnings and began gaming them."}],[{"start":490.96,"text":"Unfortunately, accounting rules about earnings aren’t clear-cut. In the short term at least, earnings can be made to look higher by various ruses: lowering depreciation charges, leasing rather than owning plant, booking sales in advance of receiving payment and so on. The top prize for earnings growth not resulting in cash flow growth went to Enron."}],[{"start":511.56,"text":"Even cash flow numbers need cleaning up sometimes. So, for instance, paying executives in shares should be treated as a business expense as it’s in lieu of salary that would otherwise appear in the cash flow statement."}],[{"start":522.92,"text":"One of the predominant valuation themes in recent years has been around return on invested capital (ROIC) — a measure of how efficiently a company turns cash investment into profit. Companies with a high ROIC tend to have powerful competitive advantages. Apple is a good illustration, with an ROIC typically over 40 per cent."}],[{"start":544.2,"text":"In the 1990s, a group of economists, including William Sharpe (who has a ratio named after him), Harry Markowitz and Merton Miller, developed the capital asset pricing model, built around ROIC."}],[{"start":556.7,"text":"It looked at a company’s returns compared with its “weighted average cost of capital” — baloney! In simple terms, it had the misfortune of making a company look like a more attractive investment if it had less equity and more debt."}],[{"start":568.72,"text":"This may have encouraged the trend for companies to buy back shares and, being fashionable in the 2000s, encouraged higher leverage ahead of the 2008 financial crisis."}],[{"start":578.72,"text":"The warning signs were there. In 2006-07, Lehman Brothers’ shares traded on a price/book ratio of more than 2.3 times, when US investment banks had previously traded around one times book."}],[{"start":null,"text":""}],[{"start":591.96,"text":"The ROIC valuation measure survived the crash and helped many investors prosper. But again, it has a weakness."}],[{"start":599.16,"text":"Investors tend to assume that companies with a high ROIC can keep reinvesting to maintain their competitive edge, so shareholder value continues to compound as these companies grow to the sky. And that means they can justify higher P/E multiples."}],[{"start":613.6,"text":"Post 2008, luxury brands and software companies performed well. They tend to have high ROICs, as they have rather little invested capital on the denominator side, leading some fund managers to own little else."}],[{"start":626.08,"text":"But in the luxury market some investors overestimated how much of the growth came from compounding internal investment rather than emerging market growth. Share prices struggled when that growth flatlined or collapsed. In software, high returns have attracted competitors, squeezing margins. AI seems likely to increase competition further. Also, if the stock-based compensation they use abundantly is treated as a business expense, they are not as profitable as some believe."}],[{"start":653.4,"text":"So where do we stand today? AI agents live on data — and investment analysis has lots of data, so already there are new valuation tools being touted to find cheap stocks and beat the market."}],[{"start":664.72,"text":"But the market is an efficient beast, and — as Goodhart suggests — if a back-tested algorithm works well, the market will discount the factors that drive that algorithm and stop it working. This is why “active quant” funds are often at the top of the performance tables just before a bust (as they are today)."}],[{"start":682,"text":"At the root of any investment decision lies a simple question: will the price I pay today be justified by future cash profits of the company (distributed as dividends or reinvested) or, alternatively, can I buy the whole business and sell the assets for more?"}],[{"start":null,"text":""}],[{"start":697.44,"text":"Valuation tools can help you find a sensible answer — but only in parallel with an understanding of each company’s business, its opportunities and the risks it faces."}],[{"start":706.36,"text":"They needn’t be overcomplicated. Warren Buffett wasn’t far off the mark when he wrote: “Read Ben Graham and Phil Fisher, read annual reports, but don’t do equations with Greek letters in them.”"}],[{"start":717.08,"text":"He also said: “The first rule of investing is not to lose money. The second rule is not to forget the first rule.”"}],[{"start":723.76,"text":"Those who invested in SpaceX at its peak above $200 a couple of months ago — a price that, at 150 times sales, would have made most stock valuers’ eyes pop out — were on Friday nursing about a 45 per cent loss. They’ll need shares to rise 80 per cent just to be back where they started."}],[{"start":742.48,"text":"Valuation techniques have been polished and updated in the wake of every financial disaster. They’ll not protect you from every risk but can help you avoid the mistakes of the past. Over the past 26 years (a span that includes three crashes) good valuation discipline has helped reduce my loss rate and made a big difference to my long-term returns."}],[{"start":761.16,"text":""}]],"url":"https://audio.ftcn.net.cn/album/a_1786277884_3129.mp3"}