I met a guy at the beginning of the year, who said that his calculations and online “research” had shown that Palantir (PLTR) was undervalued at $16, and that he had bought a sizable chunk of PLTR stock that day. Now, in June, it is trading around $8, 50% down. He’s still in it, hoping.
This is a personal anecdote, but such stories happen day in, day out. The idea of valuations can have some merit for some strategies, but wrongly applied in the wrong market environment and without risk management, it is efficiently eroding the wealth and savings of the general public.
A typical mistakes that the smaller market participants make is that they operate as if they were large mutual funds – one of the main errors here being, among others, the usage of valuation models. In this article I’m making the case that valuations can be useful for a fund manager to help decide over what stocks to spread $20 Billion and hold for a decade, but for those “smaller” operators of us aiming for more active management, they are fairly irrelevant and can be even be very damaging.
What are valuations?
But let’s start on the ground floor. Valuations for public companies and their stock can be done in various ways:
There are simple comparative metrics – such as price/earnings- or price/book ratios, vanilla, adjusted or normalized. There are absolute metrics with future predictions for dividends or cash flow, and more analytical approaches, using niche-specific revenue estimates, total addressable market, market share, you name it.
Of course, calculation metrics can be used in a mixed approach. Anybody – from ‘retail investors’, to online magazines, to financial analysts and institutional investment houses – has their own secret recipe to make valuations and influence decision-making.
The question arises: What is the purpose of stock valuation? In simple terms, they are guesstimates for the price that a stock should be trading at, to inform purchases of the stock in hopes of the current price approaching the guesstimate.
The guy from the story at the beginning of this article believed that Palantir Technologies (PLTR) should be trading somewhere substantially north of $16 at some point in the future after January 2022. I emphasize the words believed and should.
Intrinsic value
Classical ‘value investing’ prescribes to expect a mean reversion of stock price – to evaluate what is believed to be ‘intrinsic value’ of a company that the stock price will fluctuate around but inevitably return to, to buy the stock when trading below that value, and to sell when trading above.
But the utility of this intrinsic value can go wildly astray in the market when the rubber hits the road, as I will explain in a few examples further below. Essentially, valuations are a ‘business numbers‘ solution to a phenomenon that is to a large degree psychological – stock prices.
In fact, the terminology of “investment”, value “investing”, etc. is largely misguided in the stock market.
An old lesson from the world of auctions is that anything is at a given time exactly worth the price that the next guy is willing to pay for it. When I say auctions, I mean any auction – from art, to real estate, to stocks. Yes, a market that is made for a given stock (e.g. Amazon common stock) is in its essence comparable with a never-ending continuous auction with millions of people participating.
Someone buys from someone else, who is selling. Some people buy to collect (e.g. cars, handbags, shoes), some buy to generate an income (e.g. property rent, stock dividend), others speculate on the future of rising or falling asset prices: e.g. stocks, tulips, or real estate. Others sell for a profit, or to cap losses.
Intrinsic value vs. market value
The price paid in the transaction is the market value, and at the time is equivalent to a ‘personal asset value’ for the buyer – a value assigned by the owner for its own purposes, be it speculation, income, or anything else. Whether this personally-assigned value is reasonable to an outsider is a completely different question.
What something is worth is conditional on the context: the person, the time, and the market. That is true for rising and falling price trends environments. What a guy paid for stock a year or just two minutes ago does not matter. What matters for the stock price right now is how much the next guy is willing to pay for it right now, or what the other guy is willing to sell it for right now.
Stock transactions on a public exchange are a process of free price discovery – the price that something is sold for at any given time is the value that the market participants agree on that it’s worth at that time.
The very moment that market participants start acting on information that is new (or, most of the time, new to them), prices start discounting this towards a new equilibration point.
Whatever something is selling for at a given time is approximately its personal value to its holders at that given time. It does not matter what was before or after, if it is a ‘bubble’ or ‘undervalued’. An expensive stock has a higher value than a cheap stock, just like a Monet is worth more to the owner at a given time than something I just sketched up on my napkin. Price is king: Personal value equals actual value at that time. And price (read = market value) approximates this personal value at that time.
Summarizing, intrinsic/fair value is what a single or group of buyers/holders estimate that a stock’s price in the future should be once more information starts being priced in. In contrast, current stock price (personal or market value) is what the actions of market participants reflect that the stock is worth right now.
Markets are not efficient
The difference is crucial. Notice the divide between ‘is’, and ‘believe’ & ‘should’.
In a sense, value investors are purists at rejecting the efficient market hypothesis (EMH) – the idea that any market has already priced in all existing information, is perfectly equilibrated at all times, and cannot be outperformed by skill and strategy.
And they are correct – markets are inefficient and emotional, and not efficient and logical. Otherwise, accountants and computer scientists would be the best traders in the world, not disciplined and skilled supertraders like Ed Seykota. Information can be outright wrong, is delayed, lost, hidden away, feared, forgotten, misinterpreted, misunderstood, overanalyzed, overeshared, undershared, exaggerated, underestimated, diluted, withheld, disbelieved, ignored, overhyped, or acted on impulsively.
These very discrepancies and inefficiencies are what detaches price from intrinsic value. Exploiting them is what makes market participants successful, following whichever strategy or stemming from whichever background .
Value investors know this, and operate on this premise. The mere existence of the concepts of under- and overvalued are proof.
The problem with valuation
However, their error lies in that they don’t know it well enough. There is the false belief that these inefficiencies are limited to a predictable degree. That price should stay within expectable proximity to intrinsic value, and should mean-reverse in reasonable time. That irrational price overshoot, or undershoot, cannot get radically out of hand for a sustained amount of time.
The truth is, there are market environments where irrationality and the detachment of price from intrinsic value in both up- and downtrending markets can escalate into extreme states, and can remain in such extreme states for an unexpected duration.
What value investing refers to as the ‘margin of safety’ is in these environments not fully representative of how wild or despondent things can really get. Yes, price tends to mean-revert … but it tends to do so in its own time. Whoever is adamant on what price should do in such times is in dire straits.
Remember, market participants are human: Psychologically flawed, gullible, excitable, buoyant, reckless, fearful, panic-stricken, and can be erratic sheep gulping down the Kool-Aid and indulging in groupthink.
There is no limit to how extreme exaggeration, wishful thinking, illogical market behavior and impulsive action, sentiment, hubris and exuberance, sheer panic, or drawn-out despondency and subsequent irrational pricing can become in reality.
That is why the auction analogy is useful to understand emotions in the market – many a person has stepped out of an auction, regretting they got sucked into the hype or the fear of the moment, overpaying or undercharging.
Markets will at some point equilibrate again and revert to a mean. But there are environments in which no one can calculate when and after what extent of excess this will be. Until then, there is no end to how far and long price can detach from intrinsic value. Then, missing out on potential profits, or magnifying losses, is the result of relying too much on valuations to make decisions.
Valuations are inaccurate in uptrending markets
First, this is true for uptrending markets, and the individual stocks that lead such bull markets.
See Forbes Magazine discouraging readers from buying Tesla (TSLA) stock in July 2020 due to overvaluation. That did not stop TSLA stock from running another 350% of price gains over the next 16 months. That is because classical valuation factored in expectations of cash flow and other ‘number’ metrics, whereas the market (and price) discounted whatever imagination could conjure up that a disruptive entrepreneur like Elon Musk could be doing with Tesla for the next few years.
Morgan Stanley analysts shared a similar view in June 2020, stating that TSLA’s high price was not justifiable “for the next decade”. Probably true on an objective basis, but useless for weighing reward against risk in a given moment. They stated TSLA was “grossly overvalued and set to plunge” >35% as implied by their price targets. That implies to me a big ‘do not buy here’ message that would have locked you out of one of the biggest stock market winners of 2020-2022.
In October 2020, a prominent hedge fund reported being short pandemic vaccine stocks, including Moderna (MRNA) and Novavax (NVAX), based on overvaluations “detached from reality”. I don’t know when exactly these positions were started, but the detached ‘irrational’ buyers will have short-squeezed them soon after. From the date of the first media report on Oct 2, NVAX surged another 220%. Over the next 45 weeks, MRNA proceeded to rocket a mind-boggling 600% to its top. I hope that that fund manager was good at capping losses early.
He was ultimately right – in 2022, the stock is down massively. But his timing was off incredibly. His short bet still had to go bust at the time, and a speculator long the stock would have made a killing. As I said – it’s often incredible and not calculable how far and long a detachment from intrinsic value can go.
Articles on SeekingAlpha.com and The Motley Fool dismissed Zoom Video Communications (ZM) as having an “out of proportion” valuation and being “incredibly risky” in March 2020. They were discouraging people to enter ZM, one of the best leading stocks of the 2020 bull run, before its epic >300% rally.
So much for extreme and long periods of ‘overvaluation’.
Ultimately they were right, ZM is currently trading near $120, 80% off the Highs. But that’s not what I’m arguing. You would have missed everything in the middle. As I wrote above, it’s not that value investing can’t work – it’s that when it is applied to dogmatically, its timing is off for decision-making, and it disregards how much stuff can go out of whack. Measured from a proper low-risk entry point in mid-February to triggering sell rules in November, ZM gave a ~360% gain with a growth speculation strategy.
Valuations are dangerous in downtrending markets
The same is true for hostile, or bear markets, or just a dysfunctional company stock. The ‘undervalued’ price zone can extend many months or years more on the downside than the touted ‘value buy zone’ would suggest and value investors can dollar-cost average with the hope of making money in the far future.
In February 2022, the stock price of Affirm Holdings (AFRM) had declined by 75% from the top. An article on The Motley Fool recommended AFRM as a “table-pounding” buy on February 15th, based on “attractive “ valuation. Since that recommendation price is down another 60%. 1000 dollars bought initially would be worth only 400 dollars by now – valuation would have served you well, if your goal was to lose money.
In their defense, the article clearly states that it is a “long-term” idea, implying decades of holding could be necessary to show profitability. I would however interject, why not skip the potentially many months or years sitting on losses that you will have to dig yourself out again painstakingly first before making any profits?
Why not just use a growth strategy – wait until the trend starts rising sustainably again before buying the best merchandise, putting the same money in the meantime in something that actually has the potential to show you profits straight away, and get out when the trend turns?
The starkly dropping Upstart Holdings (UPST) stock was recommended by a Seeking Alpha article as a buy on January 30 based on “very attractive” valuation, post a whopping 73% decline. Since the day that recommendation was published, the price has descended another 67%. Another “long-term” idea.
In my humble opinion, giving an UPST buy recommendation in January 2022 on the basis of valuation is akin to recommending to buy Cisco (CSCO) on a dip in August 2000 post the internet bubble top.
From August, CSCO bled out in a violent 87% draw-down, and ‘value investors’ buying for the ‘long-term’ had to sit through two decades of losses in hopes of getting a profit… and even by now, June 2022, they are still sitting on a roughly 35% loss after all this time. A few select buy-the-dip value investors will inevitably have randomly bought the exact bottom in October 2002, but 99% of them most certainly did not.
As another example, Cathie wood, the glorified icon of the 2020 tech bull market, commented in December 2021 that innovative tech stocks were in “deep value territory“. Since making that statement, her flagship ARKK fund which bulk is made up of such stocks, has sold off another 59%.
No one knows whether UPST, AFRM, ARKK (or CSCO for that matter) will ever come back to its old price as ‘long-term investments‘, but are you really willing to sit on losses for a protracted amount of time, potentially decades?
I’m not saying that has to happen, but plenty of precedents exist that history could repeat itself. I’m sure the above-mentioned recommendations were put out with the best thought in mind, but when giving instructions for buying one has to also give instructions for selling and risk control.
The mistake of “buy-low sell high”
The old idea of valuation-based bottom fishing in a bear market can work. In good markets, it does so for some people some of the time (especially for the last few decades of ‘Fed-Put’ that have conditioned people to expect immediate price recoveries) – until it doesn’t anymore and the markets keep dipping and tanking.
We’ve all seen graphs of ‘intrinsic’ or ‘implied’ value, plotted against stock price to show where to buy and sell. It all sounds good and easy: buy when a stock is trading under value, sell on overvaluation, and give some margin of safety, we are told. This is actually what’s taught to aspirants of the CFA exams.
In my opinion this notion is deeply oversimplified. Real life rarely looks like this, and the fact is ignored that just because a trend has run for a while does not mean it can’t run for much longer and much higher or lower – the stock market’s law of inertia.
One only has to be wrong once while not capping losses. If you then buy low valuations on the first few pullbacks or bear rallies, your account is eroding more and more. You’re underwater quickly. ‘Dollar-cost averaging’ will drown you even more quickly, and at some point your uncle point will have been reached and you will likely sell in disgust. People underestimate the pain of grinding your account balance down slowly.
Richard Wyckoff shares an insightful story “I recall a friend who, after seeing Union Pacific sell at $291 in August, 1909, thought it very cheap at $185 and much cheaper at $160. That made it a tremendous bargain at $135. He bought at all those figures. But at $116, his capital was exhausted, and, as they put it in Wall Street, “he went out with the tide”.
Value investing with risk management
I’m not making the case that valuation-based market operation cannot work, of course it can, but only when done right – when understanding the necessity of capping losses properly.
That, or you will have to be OK with not making money for a while and sitting through potential deep draw-downs on a position for years or decades.
Without risk management, a large proportion of your many purchases can go backwards on you; hence the average amateur market participant is admonished to diversify. Even Warren Buffett, a strict value investor, admits that diversification is merely “protection against ignorance” if you don’t know what you’re doing. But then, why not learn what you’re doing right now?
Aren’t we in this to make money efficiently and swiftly with the least amount of justifiable risk? For anyone, from ‘retail investors’ up to mutual fund managers, who do not enforce proper risk control, value investing sounds more like “bet on a desire of where the price should go, then (financially) live or die with your bet’s outcome” …
What’s the alternative?
After all this negativity, I do believe there is an application of valuations that can be beneficial for market participants, from fund managers down to the individual ‘small guy’.
As the old saying goes, no statistical model is accurate, but some can be useful (or valuable, pun intended). Valuation can be useful in a different sense, when they are pursued by the right market participants. I am talking about participants whose large activity can drive long-term trends in stocks.
Institutional investors that run funds focusing on growth strategies often use valuation-based models to inform their purchases. They estimate the value of already highly-priced stocks by earnings surprise beats, raised guidance, etc. Their massive stock purchases of rapidly growing companies that are undervalued to them irrespective of already high stock prices can be the driver for price trends that the shrewd growth speculator can latch on to profit.
These models are not necessarily fundamentally better models, and these funds are often part of the very group of market participants that in a late bull market causes exuberance and extreme detachment of ‘price’ from ‘intrinsic’ value. As opposed to value investing however, these market participants understand and expect that overvaluations can become and stay radically stretched for a protracted amount of time.
Of course, even market participants with a growth-oriented strategy that also use some valuations for buy-decisions can fall for the value trap. Cathie Wood stated in Feb 2022 that her funds’ >50% draw-downs are “temporary“. In merely 4 months following that appearance, her flagship ARKK ETF has sold off another 43%, a total of 76% off the 2021 top. Wood requested that investors should “give them five years” for their “deep value portfolio” to recover.
I guess “temporary” can have different definitions; but for me, sitting 5 years on losses is a financial limbo. I expect ARKK will not come up to its old price High until 10 or 20 years from now, if lessons from history and that ridiculous amount of overhead supply of ARKK and its components’ stock are any indication.
These examples show why having sell rules, an exit strategy, and strict risk capping are key in financial markets. A good company by valuation unfortunately does not necessarily make a good stock.
Remember, ‘price’ can also be another definition of value – not ‘intrinsic’ value from an objective number perspective regarding operations of the underlying company, but a subjective ‘personal asset value’ of the stock to the owner as a speculative instrument. Also a type of value, albeit different.
Value investors bet on what they believe something should be worth. They make that bet and stay with it, whether that means profit, yearlong sideways moves, or devastating loss.
Growth speculators bet on what something is worth, could be worth, and capitalize on the trends caused by institutional money that is chasing high valuations, whatever the price may be.
They jump in when a stock makes them money, and exit when it stops doing so. They don’t argue when they are wrong, they get out. They don’t fool themselves – they’re in the markets to make money, not to proclaim that something should make them money.
They look at price, and price only – because valuations don’t pay, only price does.
