When thinking of value, think of this: What would a company be worth to another company as a business? Every company has a certain value, which can be fairly well-defined, when viewed in this light. But this is a far different concept of value than the one under which Wall Street operates.
The actual value of a stock—as a business—is only fleetingly related, if it is related at all, to the gyrations of the stock market. Again, depending on shifting earnings forecasts or interest rate fluctuations, stocks can move all over the place, like a ship passing another ship on a foggy night, without even knowing it’s there. The only time this concept of value matters is when someone is willing to step up to the plate to pay that value. In other words, when a takeover bid takes place.
My concept of a “value” situation, therefore, is: stocks that are selling at clearance-sale prices, significantly below their value as a business, where there is a reasonable possibility that someone will step up and offer to pay that value, thereby forcing the stock market to reflect that value in the stock price.
When this happens, a normal, run-of-the-mill stock that is at the mercy of all of the variables discussed here becomes a superstock. It immediately rises to its true value level—as a business— and it is no longer subject to the whims of the stock market and all of the unpredictable variables that determine where most stocks trade.
You may think that choosing stocks that are likely to become takeover targets is an impossible task. The reason why you may think this way is that you’ve probably heard this refrain over and over again from Wall Street commentators who are obsessed with earnings forecasts and stock market projections and who have no experience when it comes to selecting logical takeover candidates. But picking takeover targets is notan impossible task.
As an individual investor, you can uncover neglected and undervalued stocks that are not only selling at a discount to their value as a business, but that also have a reasonable possibility of being forced higher by a takeover bid.
By the time you finish this series of posts, you will look at the stock market and at stock selection in an entirely different way. You will become aware of news items and the availability of certain types of information that most investors are completely unaware of. You will be on the lookout for superstocks.
How can anyone define “value”?
November 1st, 2009What causes price/earnings ratios to shift so dramatically?
October 11th, 2009The major determining factor is interest rates. When interest rates rise, price/earnings ratios tend to fall. When interest rates decline, price/earnings ratios tend to rise.
There are two reasons for the profound effect of interest rates on price/earnings ratios. The first has to do with how money managers behave. The stock market is one place where a money manager can invest funds, but there are other alternatives, and the relative attractiveness of those alternatives can affect the amount of money that goes into or out of stocks.
For some investors the stock market competes for funds with the bond market. Stocks carry risk, but long-term bonds carry less risk. A20- or 30-year bond can have some awfully wild swings before the payoff (maturity) date, but some money managers look at long-term bonds as an alternative to stocks because at least they know these bonds will have a certain maturity value at a certain fixed point in time, at which time their original investment will be intact. Stocks, obviously, carry no such guarantee.
When other money managers are deciding whether to commit more or less capital to the stock market, what they’re really looking at as an alternative is the “no-risk” alternative—cash.
By “cash” we mean money market funds or short-term treasury securities, where a dollar invested today will be worth a dollar tomorrow, unequivocally and with no other potential outcome. This is the riskless alternative to the stock market, and the interest rate a money manager can earn on this riskless alternative is perhaps the major variable that determines the price/earnings multiple placed on a given level of earnings.
Suppose, for example, you are managing a pension fund for a large company. Your job is to make sure that when employees retire they will receive their pension benefits. Your company has set aside a certain amount of money for this purpose and instructed you to invest it in such a way that when the benefits have to be paid, at some point in the future, there is enough money to pay them. Ateam of actuarial accountants has prepared a very nice booklet, complete with actuarial tables, that sits on your desk. And what this booklet tells you, basically, is that if you can earn 8 percent per year on the money that’s been left for you to manage, there will be enough money to pay the retirees and everyone will be happy.
As you sit there and survey the investment scene, you see that long-term U.S. government bonds are yielding 6 percent. That will do you no good because you need to earn 8 percent or the retirees will be calling you up for loans so they can maintain their standard of living 20 years from now. The yield on money market funds, at 4.75 percent, is even less.
To earn the required 8 percent, therefore, you will have to take some risk—and that means you’ll have to invest in the stock market. Although stocks do not come with guaranteed returns, they do offer upside growth potential. And since there’s no other way to get the 8 percent you need, you take the plunge into the market.
Across the street there is another money manager in charge of another company pension fund. His job is just like yours, except his company has a lousy union and the pension benefits for its retirees are going to be a lot less than yours. According to the actuarial tables, the money manager across the street needs to earn only 6.5 percent on his investments to fund the retirement plan.
So, you’re both in the same boat—at least for now. You need to earn 8 percent and the money manager across the street needs to earn 6.5 percent, but neither one of you can get what you want in bonds or money market funds, so you’re both buying stocks.
Now, let’s suppose interest rates start to rise. The yield on the 30-year government bonds jumps to 7 percent. This is still not good enough for you because you need 8 percent to fund the pension plan. But the money manager across the street now faces an interesting situation. He needs 6.5 percent to fund his plan; he can get 7 percent in U.S. government bonds. In order to do his job, all he has to do is buy bonds and go shoot a round of golf. He will also have a lot less stress. And he must now ask the question: If I can get the 7 percent I need in government bonds, why should I be taking risks in stocks? That is a very good question, and the answer will likely be that this money manager will begin moving at least a portion of the funds he has invested out of stocks and into bonds. And if the interest on “cash” investments, like money funds and short-term treasury bills, also reaches 7 percent, he will likely move a lot more money out of stocks. In other words, as interest rates on less risky investments rise, a certain amount of money will leave the stock market to lock in that return. At 7 percent, a certain number of investors will determine that they do not need to take the risk the stock market entails. At 8 percent, a new round of money managers will make the same decision. Each uptick in interest rates will suck money out of the market because the lesser-risk return meets some investor’s goal, which is one reason why rising interest rates almost always put downward pressure on the stock market.
The profound effect of interest rate movements on stock prices is the major reason Wall Street is so obsessed with Alan Greenspan and the Federal Reserve, even to the point where CNBC analyzes the size of Greenspan’s briefcase as a potential clue as to whether the Federal Reserve is about to shift its interest rate policy.
There is another reason why rising interest rates usually mean lower stock prices. It’s a bit more complicated but its worth knowing, and it explains a big part of the mystery of the wildly gyrating price/earnings ratios touched on earlier.
This concept is called “discounted present value,” and what it boils down to is this: If you know what a company will earn over the next 10 years, what is that future earnings stream worth today?
Again, what the market is willing to pay today for those future earnings is the price/earnings ratio.
Let’s use this example:
Suppose Totter’s Rollerblades Inc. (TRI) is estimated to earn a grand total of $50 per share over the next 10 years. This means if you buy one share of TRI today, you are buying a piece of that future earnings stream. What is that future earnings stream worth right now? Put another way, what amount would you have to invest today to have $50 ten years from now?
Answer: It depends on the level of interest rates. The higher the level of interest rates, the less you must invest today to get that $50 ten years from now. In other words, when interest rates are high, the present valueof that $50 will be less than it would be when interest rates are lower. High interest rates will result in the present value of that $50 ten years from now being lower, while low interest rates will result in present value being higher.
For example, if you want to have $50 ten years from now and interest rates are 10 percent, you only have to invest around $19
today. But if interest rates are at 5 percent, you will have to invest $31 today to get that $50 ten years from now.
Think about that for a moment. Ten percent interest rates make the present value of $50 ten years from now worth $19. Five percent rates make the present value $31. In other words, given the earnings projections for Totter’s Rollerblades Inc., the present value of those earnings can be worth anywhere from $19 to $31, depending on the level of interest rates. And if you think of a stock price in terms of present value, you can see how interest rates can have a profound effect on what Wall street will be willing to pay today for a projected future earnings stream. Same company, same earnings projections—the only difference is what those earnings are worth right now in any given interest rate environment.
That, in simplified terms, is how most stocks trade. For the most part they’re at the mercy of earnings forecasts that are constantly changing and may or may not be on the mark, and they’re at the mercy of interest rate movements that cause professional money managers to move into and out of stocks in general and that will alter the value of your investments as rates fluctuate, even if earn- ings estimates are accurate.
Where does that price come from?
October 1st, 2009It comes from two places: (1) earnings expectations and (2) the present value the market is willing to place on those earnings expectations. Think of a stock as representing a small piece of ownership in an estimated future stream of earnings. Those earnings are unknown, and investors rely on the best guesses of Wall Street analysts to determine what they’ll be. When you buy a share of stock today, you’re buying a stake in that future earnings stream.
Of course, analyst estimates of that future earnings stream may be wildly off the mark, which adds another major variable to the question of determining value. But let’s assume, charitably, that the analysts are going to get it right and you know precisely what a company will earn over the next 10 years.
Even so, you would have only half the equation because the next question would be: What is that future earnings stream worth today? What the market is willing to pay for a given level of earnings is the price/earnings ratio. And if you think predicting earnings is difficult, you haven’t seen anything yet.
The stock market at various points along the way has decided that stocks were worth anywhere from six times earnings (in 1949) to as much as 28 times earnings in 1998. And that ratio has gyrated wildly along the way, rising and falling sharply, so that a stock earning $2 per share could be worth $40 one year and only $20 the following year. Same company, same earnings—but a wildly different con-cept of value.
What Is Value?
September 25th, 2009You’ve heard a lot about “value investing” recently, but what exactly does that term mean? Generally, value investing involves buying stocks that are out of favor and therefore undervalued relative to other stocks. That sounds like a sensible way to invest until you ask two key questions:
1. What is “value?”
2. Why can’t a stock that is undervalued remain undervalued, theoretically, indefinitely?
It’s all well and good to say that in the long run the stock market will adjust undervalued stocks to a more reasonable value, but as John Maynard Keynes pointedly reminded us, “In the long run we are all dead.”
What we need is an investing approach that not only focuses on “value” but also provides for some sort of catalyst—some outside event—that will literally force the stock market to take an undervalued stock and reprice it at a higher, more appropriate value. Let’s start with this premise: A stock is worth what the stock market says it is worth on any given day—no more, no less. You can argue that a stock is overvalued or undervalued, but if you want to buy it or sell it, there is only one value that really matters: the price the stock market is placing on that stock right now.
collective decision making
September 19th, 2009The major alternative to market organization is collective decision making, whereby the government, through the political process, makes decisions for buyers and sellers in an attempt to solve the basic economic questions facing the economy. The government may maintain private ownership, but uses taxes, subsidies, and regulations to resolve the basic economic questions. Alternatively, an economic system in which the government also owns the income-producing assets (machines, buildings, and land) and directly determines what goods will be produced is called socialism. Either way, individual planning and decisions are replaced by central planning and decisions made through the political process. These decisions can be made by a single dictator or a group of experts, or through democratic voting. Political rather than market forces direct the economy, and government officials and planning boards hand down decisions to expand or contract the output of education, medical services, automobiles, electricity, steel, consumer durables, and thousands of other commodities.
This is not to say that the preferences of individuals carry no weight. If the government officials and central planners are influenced by the democratic process, they must consider how their actions will influence their reelection prospects. That means they will listen to the voices of the voters to win over a majority of them. Otherwise, like the firm in a market economy that produces a product that consumers do not want, their tenure of service is likely to be short. However, under central planning the indirect exit method of communicating is much more difficult. Although people can use the direct or voice method to communicate their preferences by lobbying government officials or casting votes in an election, they generally cannot use the indirect exit option because they cannot refuse to pay taxes or to quit purchasing a good or service that is provided by government. For example, families who send their children to private school must continue to pay the same amount in taxes to support the public school system as they would if they kept their child In public school. Oftentimes, people “vote with their feet” and leave one political jurisdiction to move to another. This is frequently seen when people move to better school districts. It is much easier, however, to move between school districts than between states or nations.
In summary, both market organization and central planning face the same basic economic questions. A basic difference between them is that the market system, with its exit option, allows for a wider variety of products and creates constant competition among suppliers, whereas the central planning system, in a democracy, responds primarily to the votes of the majority. In varying degrees, all economies use a combination of both of these methods of economic organization. Even predominantly market economies will still use taxes, subsidies, and some government ownership to direct and control resources. Similarly, predominantly socialist economies will, to some degree, use markets to allocate certain goods and services.
Gains from innovation
September 19th, 2009Trade also makes it possible to realize gains from the discovery and dissemination of innovative products and production processes. Economic growth involves brain power, innovation, and the application of technology. Without trade, however, the gains derived from the discovery of better ways of doing things would be stifled. Furthermore, observing and interacting with other people using different and better technologies often encourages others to copy successful approaches. People also modify the technology they observe, adapting it for their own purposes. This sometimes results in new, and even better, technologies. Again, gains from these sources would be far more limited in a world without trade.
Can you imagine the difficulty involved in producing your own housing, clothing, and food, to say nothing of radios, television sets, dishwashers, automobiles, and telephone services? Yet, most families in North America, Western Europe, Japan, and Australia enjoy all these conveniences. They are able to do so largely because their economies are organized in such a way that individuals can cooperate. specialize. and trade. thereby reapins the benefits of the enormous increases in output-in both quantity and diversity-that can be generated. On the other hand, countries that impose obstacles that retard exchan, me-either domestic or international-hinder their citizens from achieving these gains and more prosperous lives.
Market organization
September 12th, 2009Private ownership of productive assets, voluntary contracts (often verbal), and market prices are the distinguishing features of market organization. Market organization is also known as capitalism. Under market organization, private parties are permitted to buy and sell ownership rights of their assets at mutually acceptable prices. The government plays the limited role of rule maker and referee. It develops the rules, or the legal structure, that recognize, define, and protect private ownership rights. It enforces contracts and protects people from violence and fraud. But the government is not an active player in the economy. Ideally, it avoids modifying market outcomes in an attempt to favor some people at the expense of others. For example, it doesn’t prevent sellers from slashing prices or improving the quality of their products to attract customers from other competitors. Nor does it prevent buyers from outbidding others for products and productive resources. No legal restraints limit potential buyers or sellers from producing. selling. or buying in the marketplace.
Under market organization, no single individual or group of indii iduals guides the economy. There is no central planning authority, only individual planning. The three basic questions are solved independently in the marketplace individual buyers and sellers making their own decentralized decisions. Buyers and sellers decide on their own what to produce, how to produce it, and whom to trade it to. based on the prices they themselves decide to charge.
In markets, individual buyers and sellers communicate their desires and preferences both directly and indirectly. They directly voice their desires 1% hen they buy or sell by advertising, whether in print or broadcast. or informally by word of mouth, on bulletin boards, and by letters of request and complaint and other means. They communicate indirectly by exiting or entering exchange relationships, as when they stop purchasing Coke and switch to Pepsi. The indirect, or “exit,” option gives special power to their voiced, or direct, statements. Indeed, sellers, when markets are competitive, often hire experts to seek out the statements and desires of potential buyers. Buyers, too, are eager to know what sellers want-special terms of payment or delivery, for example-hoping that sellers might be willing to reward cooperation with a better deal.
Human ingenuity and the creation of wealth
September 5th, 2009The size of a country’s “economic pie” is most easily thought of as the total dollar value of all goods and services produced during some period of time. This economic pie is the total amount of wealth (or value) created in the economy. It is not some fixed total waiting to be divided up among people. It is simply a statistic-a grand total, calculated by adding up the wealth created by each of the individuals in the economy. Many errors in economic reasoning stem from the incorrect notion that the size of the economic pie is fixed.
On the contrary, the size of the economic pie reflects the physical effort and ingenuity of human beings. It is not an endowment from nature. Economic output expands as we discover better ways of doing things. So over time, it is human knowledge and ingenuity-perhaps more than anything else-that limits our economic progress. If Jim, a local farmer who normally produces $30,000 worth of corn each year, finds a better growing method enabling him to produce $40,000 of corn each year, he has created additional wealth. But Jim has actually created more than the $10,000 in extra wealth. The $10,000 is only his share of the gains from the additional trades made possible by the extra corn he grew. Exchange makes both buyer and seller better off, so the total wealth created by Jim includes not only his $10,000 but also the gains of all of the buyers who purchased corn from him as well. This highlights an important point: in a market economy, a larger income for one person does not mean a smaller income for another. In fact, it is just the opposite. When a person earns income, he or she expands the economic pie by more than the amount of the slice that he or she gets, making it possible for the rest of us to have a bigger slice, too. When a wealthy entrepreneur, such as Bill Gates or Henry Ford, has an income of, say, $1 billion per year earned through voluntary exchanges in the marketplace, he has enlarged the economic pie for everyone by an even larger amount. Here’s how:
Suppose that Linda, a freelance graphic artist, pays $175 for a new software program developed by Bill Gates. As a result, she can do twice as much work in the same amount of time. Because she’s more productive, Linda can earn more than enough additional income with the software to justify her purchase. In addition, the businesses she serves are also likely to be better off because the software makes it possible for her to give them more and better service and a lower price for her services. Thus, while Bill Gates gained, so, too, did Linda and her customers.
Similarly, although Henry Ford certainly became rich, he also greatly increased our ability to transport goods, services, and people. In the process, he made it possible for many others to achieve higher living standards than would have been possible in his absence. Had Stephen King never written a novel, not only would he not be as rich, but we would all be poorer for never having had the opportunity to read his novels. When income is acquired through voluntary exchange, people who earn income also help others earn more income and live better, too.
Gains from Macc production methods
August 11th, 2009Trade also promotes economic progress by making it possible for firms to lower their perunit costs with mass production. Say a nation isolated itself and refused to trade with other countries. In an economy like this, self-sufficiency and small-scale production would be the norm. If trade were allowed, however, the nation’s firms could sell their products to customers around the world. This would make it feasible for the firms to adopt more efficient, large-scale production processes. Mass production often leads to labor and machinery efficiencies that increase enormously the output per worker. But without trade, these gains could not be achieved.