Michael Mauboussin – Market Myths And Market Reality

Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).

Visit his site at: michaelmauboussin.com/

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Michael Mauboussin

  • Exploration of market myths and market reality draw a picture of an economically sound stock market.
  • Popularly used valuation techniques offer the advantage of simplicity at the expense of accuracy.
  • A value-based model incorporates good theory and good practice and should be the primary tool in capital allocation for companies and investors alike.

This text is based on a presentation given at the annual National Investor Relations Institute (NIRI) conference in June 1997. The session was originally entitled “Valuation: A to Z.” We thank the NIRI for allowing us to reproduce this speech.

Introduction

Good morning. My objective today is to walk through, very logically, why we think value-based analysis is a powerful tool for both investors and the corporations. We’ll approach the issue in three different ways. First, we’ll talk about stock market myths and stock market reality. Next, we will evaluate valuation techniques, weighing the pluses and minuses of each. Finally, we will lay out the case for a value-based model.

Michael Mauboussin - Market Myths And Market Reality

Let’s go right to the first section—stock market myths and reality. I would like to preface these comments by emphasizing that I work on the sell side. Everyday I deal with companies and investors. So I have to be pragmatic, and must try to understand what it is that really matters. My objective in this analysis is to be practical, as well as value-added, for the investors.

The first popular myth is that earnings per share matter. Why would anyone be of that opinion? First, earnings are widely cited in the financial press, it is what companies talk about—earnings are the common language of Wall Street. Second, earnings are the result of audited financial statements—there is authority behind the numbers. Finally, stock prices change, and in some cases significantly, based on earnings per share reports. This morning we woke up with the unfortunate news that Cabletron is going to miss the consensus EPS for the quarter by 15%: the stock tumbled by almost 30%. The fact that earnings will be below current expectations and the stock is down suggest a high correlation between the two events.

We suggest that earnings are really a proxy for what is going on, and that earnings per share figures, in and of themselves, are to be used with a lot of caution. In order to develop this point we used data from the food industry. (See Figure 5.) We took the fiscal 1994 numbers for a handful of major packaged food companies, started with the reported earnings per share number, and sorted through those items that differentiated the reported numbers from the cash numbers. We all know that because of varying, acceptable accounting standards, amortization of goodwill and other sundry issues, reported earnings per share and cash earnings can be two very different things. So we made the necessary adjustments to show the “cash” earnings for every dollar of reported earnings. In 1994, for every dollar of reported earnings Kellogg delivered $1.39 in cash earnings; ConAgra generated over $2.08 in cash earnings. So when we are talking about earnings, and applying multiples to those earnings, it doesn’t seem to make sense to use comparable multiples on two business that have vastly different economics, no matter what their reported numbers suggest. Earnings per share, then, are a proxy for cash, but only a proxy, for cash.

Michael Mauboussin - Market Myths And Market Reality

Now we go to the next level of reasoning: earnings themselves may not matter, it is really earnings growth that everyone cares about. Why would we think that? First, earnings growth tends to be held up as an absolute good. In almost every organization, managers are drilled to believe that growth is good. Very rarely do managers ever consider that growth can be bad, and I am going to demonstrate in a moment why EPS growth can be bad. Second, investors appear to be after growth. You hear it all the time: the faster the growth rate, the better. Finally, in most cases executive compensation is tied to some growth metric. Before I go on to explain why I don’t think that earnings per share growth, in and of itself, is important, let’s do a mental exercise:

Let’s pretend I am an unlimited source of capital. Everyone in this room can come to me and I will give you all the money you want. There is just one catch: the expected return on the capital I give you, not the explicit return, but the implicit return, is 10%. Now, let’s say you can go out and reinvest the money I give you at 8%. I give you capital with a 10% “cost” and you reinvest it at an 8% return. Now here is the question. What is your earnings per share growth going to be for this venture? The answer is, It is going to be anything you want it to be! All you have to do is keep coming back to me for more money, reinvest it, and you will generate earnings growth at whatever rate you choose. Clearly, the more rapidly you grow earnings the worse off you are, because you are investing below the required rate of return.

That may make sense, but how does it apply to the real world? The answer is that the primary source of capital for most companies is retained earnings. (Roughly 75% of investments are funded internally.) Retained earnings have an implied opportunity cost—that is what shareholders could earn on that capital if they invested it in other ventures of similar risk—but most managers think of retained earnings as “free” money. Hence, managers who take cash generated by the business and reinvest it at below appropriate rates of return in order to drive earnings per share are doing their shareholders injustice. Mind you, investing in projects that do not earn the costs of capital may drive earnings per share growth, but will clearly destroy value. This type of investing goes on every day in corporations around the world.

Here are some other illustrations in the last few months that demonstrate the earnings/value dichotomy. Tyco International—which has been a very good performing stock, by the way—announced in March it was acquiring a company called ADT. Tyco is in the building supply business, ADT is a leading home security company. It

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