A map is not the territory it represents, but, if correct, it has a similar structure to the territory, which accounts for its usefulness.
The stories told by investors can be broadly grouped into two categories. Fundamental investors believe that the share price is closely linked to the company it represents:
“Remember that a share of stock represents a part of a business and is not just a piece of paper.”¹
Fundamental investors therefore create and consume stories about the company, believing that over time the share price will “map” the territory of the company. The function by which this mapping occurs is called value. Whilst there are many different value stories, they are all based on this premise that the share price is linked to the performance of the business.
In constrast, other investors, (often referred to as traders or speculators) believe that shares are pieces of paper with their own distinct story. They do not necessarily deny the existence of a link between the share price and the company, but as Nassim Taleb² notes,
“price and reality as seen by economists are not the same thing. One may be a function of the other but the function is too complex to map mathematically.”
Each of these narratives has a camp of true believers and its own hall of fame. For those in the Fundamental Value camp, theirs is the rational view of the world, based on fundamental reality as opposed to paper fiction.
The Fundamental Value Story
There are good reasons for believing that Value Stories are more enduring and more capable of understanding than other stories. However, it is problematic to deny that this approach is categorically different from the story telling of traders. Stories are the bedrock of Value in two important ways:
- At a macro level, as Yuval Harari notes, most human activity is based on an “imagined reality”. Some stories are believed by more people over longer periods, but they remain stories nonetheless;
- At a stock specific level, the vast majority of returns for most investors will come from the return on the piece of “fictional” paper, rather than the return of “real” cash in the form of dividends. The price of this piece of paper at all times relies on stories – whether they be fundamental or otherwise.
Recognising that Fundamental Value is simply a subset of a broader collection of stories does not diminish its importance. Rather, it prevents blind faith in a reality that doesn’t necessarily exist.
The Fundamental Value story can be traced back to the publication of Security Analysis almost 90 years ago by Ben Graham. In the intervening years his words have gained an almost religious following. Funds, newsletters and media pundits spruiking “intrinsic value” are too many to mention.
But Graham’s view of the world was much more pragmatic than most modern day value adherents would care to admit. Despite being the founder of value, he understood that this was but one element along a continuum of share price drivers. He summarised this in perhaps the most frequently misquoted passage in investment history:
“It will be evident from the chart that the influence of what we call analytical factors over the market price is both partial and indirect – partial, becuase is frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather … the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.“
The market is a story comprised of both analytical (value) and speculative elements.
Elements of the Value Story
Like all good narratives, the plot of the Value Story is underpinned by a consistent set of elements:
- Value vs Valuation: Although often confused, the concept of value is distinct from the process of valuation. Believing in the idea of value – that cash flows and share prices will ultimately converge, is not the same as putting faith in a particular process of valuation. An investment can be made on the idea of value even if no valuation has been undertaken. As Ben Graham noted in Security Analysis all those years ago:
“it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.”
- Probabilistic: A corollary of the distinction between value and valuation is that value is uncertain and therefore any valuation needs to be understood as a probabilistic assesment. This flys counter to the standard practice of reporting valuations to two decimal places (or more!), or ranking stocks simply on their discount or premium to valuation. Again Ben Graham nailed this early:
“Our notion of the intrinsic value may be more or less distinct, depending on the particular case. The degree of indistinctness may be expressed by a very hypothetical ‘range of approximate value,’ which would grow wider as the uncertainty of the picture increased.”
- Personal: A further corollary of the probabilistic nature of value is that it is a personal, rather than universal, concept. We all have legitimate differences in risk preferences and will also be exposed to different degrees of reward (e.g. tax). Therefore, there are many ‘correct’ ideas of what represents value and what is an appropriate valuation. Graham again:
“the personal element enters to a greater or lesser extent into every security purchase”
- Dynamic: The final element of value is that it is ever changing. It changes through the mere passage of time and also continual changes at an economic, industry and company level. Each of these changes impacts to some degree the probability distribution that investors are exposed to. Should a valuation reflect each of these change, or should it attempt to estimate a long term equilibrium value for these factors? Whilst the share price is constantly adjusting, valuations generally don’t. This dilemma highlights that valuation and momentum and not necessarily distinct ideas, but are part of a continuum. And of course, once again, Ben Graham had this sorted:
“nearly all security commitments are influenced to some extent by the current view of the financial and business outlook. In speculative operations these considerations are of controlling importance…. Security analysis, as a study, must necessarily concern itself as much as possible with principles and methods which are valid at all times – or at least, under all ordinary conditions.”
Because of the probabilistic, personal and dynamic nature of value and valuation, there is no one tool that is best in all situations. We can group the multiple tools used to explain the Value Story into the following buckets:
- Discount Models: Often regarded as the purest form of valuation, they are also potentially the most dangerous. Examples include the DCF, DDM and IRR.
- Capitalisation of Earnings: The simplest and most ubiquitos of valuation tools. Examples include PER, EV/EBIT, Dividend Yield.
- Asset Based Models: Considered old fashioned, but still very useful in the correct circumstances. Examples include P/NTA, P/BV.
- Excess Cash Flow Models: The consultants favourites, a souped up version of the DCF. Examples include CFROI, EVA.
- Proxy Models: Useful when there are no profits and also as a cross check to profit based models. Examples include EV/Sales, EV/Subscriber.
- Hybrid Models: Sometimes used as a shortcut between capitalisation of earnings and discount models. Examples include PEG, PER x P/BV.
- Contingent Claim Models: For asymetric or one sided bets. Examples include Options pricing models.
The relative strengths and weakness of these different tools are best understood by using them in context. This applies to both the narrow concept of value and also within the broader investment framework.
1. This quote is from Walter Schloss, but similar statements have been made by many others. Buffet and Graham spring quickly to mind.
2. Taleb, Nassim Nicholas. Antifragile: Things that Gain from Disorder (Kindle Locations 3558-3559). Penguin Books Ltd. Kindle Edition.
3. Harari, Yuval Noah. Sapiens: A Brief History of Humankind (Kindle Locations 482-484). Random House. Kindle Edition.