In Today’s Overheated Market Control Risk In Your Retirement Portfolios With Sound Valuation by Chuck Carnevale, F.A.S.T. Graphs
Investing money in anything is never without risk. When investing in liquid investments, prices can and do fluctuate daily. Importantly, all liquid investments can fluctuate in price, and that includes both stocks and bonds. I mention this because price volatility, especially when investing in common stocks, represents one of the biggest risks that investors focus on, some to the point of obsession.
However, there is an important distinction that many people either fail to realize or consider. Price and value are not the same things. There are many that argue that the value of anything is the current price that someone is willing to pay. In the short run, they are correct. When dealing with liquid investments, if you are required to immediately sell the asset, for whatever reason, its value will be only what someone else is willing to pay you for it at that moment in time. Therefore, in that situation, price and value is the same thing.
On the other hand, to the longer-term oriented investor, who doesn’t need to sell an asset in a panic, it’s critical for them to know the difference between price and value. Understanding this difference is rooted in the reality that ultimately a business, any business public or private, derives its value based on the underlying performance that the business generates. These value drivers include, but are not limited to, operating results such as earnings, cash flows, sales (revenues) and dividends.
Intrinsic Value VS Daily Price Action
Common sense would indicate that the true intrinsic value of a business based on the fundamental metrics described above doesn’t change very much in a single day or hour. However, in a liquid auction market, it is not uncommon to see the price of a company’s stock change rapidly from one hour to the next.
With liquidity comes price volatility, as individual investors are continuously presenting bids or asking prices at which they’re willing to buy or sell a given stock at any moment in time. This dynamic process is continuously creating overvaluation or undervaluation of a given company’s stock price relative to its fundamental value.
In other words, at any moment in time the market can be mispricing a stock either over or under its true worth. However, as previously stated, common sense tells us that the true value of a large multinational business, or any business for that matter, cannot possibly change as quickly or as much as daily price quotations would indicate.
At this point, it is important to acknowledge that there are many people that believe that assessing fair value is totally subjective; I am not one of those people. Those who hold this view tend to be very price focused. Regardless of the underlying fundamental strength of the business behind the stock, if the price goes up it’s a good stock, if the price goes down it’s a bad stock.
To my way of thinking, people who believe that price and value is the same thing are denying themselves the opportunity to recognize a bargain, or perhaps more importantly, recognize the high long-term risk associated with excessive overvaluation. This brings to mind a famous Oscar Wilde quote. In answer to the question what is a cynic, Oscar Wilde allegedly quipped “A man who knows the price of everything and the value of nothing”
Classic Lessons in Valuation
What follows are what I consider two classic examples representing lessons on valuation. The reason I consider these classic examples is because I believe they clearly and undeniably illustrate the reality that the stock market can, and does, incorrectly price publicly traded companies. Admittedly both of these examples are extreme cases of incorrect stock pricing by the market. However, it is often by examining the extreme that true insights can be obtained.
In addition to providing evidence that the market can and does incorrectly price stocks at times, these examples also provide lessons on the importance of fair valuation. To state this more plainly, these examples also show that if you pay more than fair value when investing in even the best of companies, you can lose money, and do so, while simultaneously taking on too high of a risk. But importantly, the high risk is often obvious and easily avoided if you pay attention to valuation.
Finally, these two examples clearly illustrate the distinction between price and value discussed in the introduction. Stock prices in the short run can be driven by strong emotions such as fear and greed. These two examples present vivid examples of both fear and greed at work. The intrinsic value of a business is driven by fundamentals and can be calculated within a reasonable degree of certainty. Once this calculation is made, sound investing decisions can be made and implemented.
Cisco Systems, Inc.
The first graph on Cisco (CSCO) plots earnings and dividends only since 1996. Simply put, this is a picture of Cisco the business. Over this timeframe, operating earnings grew at the above-average rate of 13.2% and the company instituted its first dividend at the beginning of fiscal year 2011.
Considering that Cisco is a tech stock, the consistency of the company’s operating earnings history is quite remarkable. There was some cyclicality during both recessions, but importantly the company remained profitable. In other words, Cisco did not lose money in either recession. There are few businesses in the overall market that can match Cisco’s historical operating record.
Yet in spite of this historical operating excellence, Cisco is one of the most maligned stocks in the market. Retired CEO John Chambers has also been severely criticized and often referred to as one of the worst CEOs in all of corporate America. I believe that criticism is unjustified based on the business performance that Cisco achieved under his reign as illustrated below.
With this next graph I bring in monthly closing stock prices since fiscal year 1996 and here we find a clue as to why Cisco, and ex-CEO Chambers, has been so severely disparaged. People often refer to the company as a dog that produced dead money for more than a decade. Ironically, they are correct, but not because Cisco the business performed poorly, nor because John Chambers was not an excellent CEO.
The culprit was the stock market because it incorrectly priced the stock relative to the business. Management is not responsible, nor did they have control of the price that the market placed on their shares. All management can do is run the business, generate earnings growth and cash flows, and return capital to shareholders via dividends or share buybacks when appropriate. Market price is often independent of those actions.
The orange line on the following graph represents a fair value P/E ratio of 15, which is appropriate for a company that produced the operating results that Cisco historically has. However, at the peak of excessive valuation in calendar year 2000, Cisco shares were being valued with a P/E ratio in excess of 160. Simple mathematics would indicate that this was approximately more than 10 times the company’s intrinsic value.
Cisco’s poor historical performance was not a result of it being a