A Valuation Introspection

Equity and bond markets are at or near all-time highs and with the unprecedented amount that the word “unprecedented” has been used in the past 18 months, many investors are questioning the valuations of these markets. Some index levels and certainly a few individual company valuations seem to beg the question of how much future investment returns have arrived to the party early. Given the geopolitical stresses with places like China, Iran, and Russia, the confusing economic recovery dynamics around labor and inflation, the on-going specter of further COVID-19 health concerns, vast monetary and fiscal stimulus across the globe and their accompanying deficits and debt levels, and rising environmental, social and corporate governance concerns, we agree that it is prudent to consider just what current security prices mean in the context of future expected returns. Unfortunately, valuation is not an exact science, and as always, everything we would need to know to precisely value each investment is not yet known.

Valuing investments is a task with a range of difficulty that encompasses the obviously easy to the absurdly difficult. The value of the $20 bill (Federal Reserve Note) in your wallet and the value of a money-market account represent the easy to value investments of today. A dollar today is worth, well, a dollar. A U.S. Treasury Note with a 1.5% coupon maturing in 10 years introduces some additional time-value of money, inflation, and interest rate forecasting considerations, but such securities typically have small daily or weekly price fluctuations. Equity securities, however, present an unending litany of potential variables to consider for “proper valuation.” That list may include forecasts of future economic growth, changes in technology, competitive industry dynamics, management quality assessments, geopolitical developments, tax policy, federal deficit levels and spending, and the way that investors may feel about any of these issues between now and the end of the relevant investment horizon. For this reason and because humans are emotional beings, equity security prices can dramatically change on an annual, weekly, or even daily basis. And while we focus upon the valuation of equity securities here, one should not forget that the investment landscape offers more esoteric adventures even further abroad in such things as derivative securities, asset-backed securities, private equity, commodities, art, nonfungible tokens, cryptocurrencies, collectible memorabilia, and perhaps some of them will be similar to humanity’s previous experience with tulips[1].

Much of equity investing today focuses upon post-WWII experiences and analogues because that is the relevant lived experience of many institutions and the investors making the buy and sell decisions of today. Some, like Warren Buffet or Charlie Munger, remember lessons learned that date back further, perhaps back to the Great Depression, while others attempt to incorporate prior history’s lessons from study of these past periods. One of our firm’s investment heroes is Tom Gayner, Co-CEO of Markel Corporation and head of its investment operations. Tom had a mentor when he worked at Davenport, Ned Reynolds, who shared, “Tom, the secret of success in the investment business is lasting the first 30 years. The rest is just a replay.” Tom, likewise, has shared this anecdote since he began his investment career in 1984. When 2014 arrived and having survived the Great Financial Crisis, he thought that he was entering the “replay” phase of his investment career. However, about 5 years later the Covid-19 pandemic has perhaps made the case that 35 or 40 years may be required to see everything! Current price-to-earnings multiples, government debt levels, fiscal deficits, inflation levels, and interest rates are inevitably compared against those that existed in the 60s, 70s, 80s, etc. Many of these risks have either revisited us from the 2000 or 2008 market crashes and recessions or have never, in fact, left us. But even the “tried-and-true” measures of these past crashes, in our current strange economic period, do not universally point to overvaluations. The graphic below from J.P. Morgan Asset Management’s “Guide to the Markets” shows that S&P 500 valuation levels are only about 1.6x standard deviations from average on several measures, not nearly a level that statisticians would argue is dangerously high, and the Earnings Yield spread is in fact, negative. We believe that much of what is affecting business valuations today versus the past are recent and accelerating technological advances, changed accounting standards, vastly different monetary policy actions (low, zero, and even negative interest rates as well as central bank purchases of massive amounts of financial securities), incredible fiscal responses (enhanced unemployment benefits, PPP loans, etc.), and just strange human behaviors that do not allow for a good historical rhyme on which to bend our ears. So, while these comparisons are valuable tools and promote a rational evaluation of market and individual company prices, they cannot be used formulaically or in isolation.

A sensible prerequisite for investing in equities is a long-term investment horizon yet most investors, even those looking at forward-year earnings valuations, lose sight of what that means. Most of the value of a company is not derived from its earnings this year, or next, or even the cumulative earnings in the next 5 years, but rather the rest of its lifetime, however long that might be. This can be illustrated in a simple analysis of an equity analyst’s discounted cash flow (DCF) model for an important online retailer. These valuation models use “discount rates” that incorporate quantitative facts, like prevailing long-term interest rates and the coupon rates of company-issued debt, as well as qualitative risk factors to place a present, lower value, on the sum of all anticipated future cash flows. Despite its already large size, this retailer, media company, and computer services provider’s growth is expected to be robust for many years. Stunningly, the value of discounted 2022 cash flows from earnings represent less than one percent of its overall DCF, and the cumulative sum of the next 10 years’ earnings only accounts for 19% of the analyst’s calculation of intrinsic value. While a company’s valuation may be stretched relative to this year’s or next year’s earnings expectations, those near-term cash flows represent a tremendously small amount of its overall value. Holders of stocks of identified high-quality companies should remain focused on the destination, the projected long-term value, and that should be the north star to guide their investment course, not the current price flashing on CNBC.

In general, as an asset’s price increases, its future return potential decreases. This is specifically true when considering high credit quality fixed income securities: a newly issued 10-year U.S. Treasury Note with a 1.5% coupon will provide a yield to maturity of 1.5% (meaning 1.5% earned per year) over its lifetime. If on the first day of trading the market price increases by 5%, the remaining return to maturity will only be 0.97%. That’s just the math. However, the valuation of equities is a probabilistic exercise of potential outcomes. In a simple thought experiment, two new companies have created a new widget that will have incredible worldwide adoption, and we consider 3 possible futures: 1) Company A monopolizes the entire market; 2) Company A and one other company garner nearly total market share with huge pricing power; 3) Multiple companies compete in a cutthroat commoditized widget market. Our estimation of value for Company A will depend upon what probability of each potential outcome we assign and the value at the end of each of those future branches. However, if tomorrow it becomes obvious that Company A is heading down a path of positive outcomes (either 1 or 2) then we would immediately be willing to pay a much higher price to own Company A now, given the rosiness of its future. Current disruptive technology companies, often in response to accelerated technology adoption because of the global pandemic, present this type of valuation framework and a company’s stock price that is now 20% above a prior normal valuation to sales, earnings, or cash flows, may represent a better deal given its probability-weighted future value has increased so much.

https://app.hedgeye.com/insights/82330-cartoon-of-the-day-air-drop

So, we agree that there are plenty of signals flashing warning signs, especially around security valuations and speculative investment behavior. However, the opportunity risk of cash versus owning good companies and the immense difficulty (and tax consequences) of correctly market-timing sales and purchases of these investments is incredibly important in the context of owning good businesses that compound wealth. If you already own a great business with good management and a long runway of future growth, the greater risk is often in selling it too soon. Furthermore, the valuation signals around interest rates, real-estate, and other less liquid or new “investments” are more concerning. Some of these historical safe-havens, like fixed-income securities, seem more of a guarantee of return-free risk rather than risk-free returns. Our preferred course of action remains a natural build-up of cash that results from dividend accumulation and the normal course of prudent investment sales and a corresponding lack of new investment opportunities.

[1] During the Dutch Golden Age contract prices for some bulbs of the recently introduced and fashionable tulip reached extraordinarily high levels, and then dramatically collapsed in February 1637. It is generally considered to have been the first recorded speculative bubble or asset bubble in history. In many ways, the tulip mania was more of a hitherto unknown socio-economic phenomenon than a significant economic crisis. Source: Wikipedia, see “Tulip mania”

Redmond Asset Management, LLC July 2021

The opinions contained in the preceding commentary reflect those of Redmond Asset Management, LLC. The stated opinions are for general information only and are not meant to be predictions or an offer of individual or personalized investment advice. They also are not intended as an offer or solicitation with respect to the purchase or sale of any security. This information and these opinions are subject to change without notice. Any type of investing involves risk and there are no guarantees. Redmond Asset Management, LLC does not assume liability for any loss which may result from the reliance by any person upon any such information or opinions.

Redmond Asset Management, LLC (RAM) is an independent, SEC registered investment management firm located in Richmond, VA and is not affiliated with any parent organization. RAM was founded in 2005 and registered with the SEC on 22 Dec 2005. The company offers investment management services for equity, balanced and fixed income portfolios to corporate, institutional, and individual investors.