What’s the story—and who’s telling it?
I’ve often said that the economy is as much art as science and the same could be said about market valuations. While there are a plethora of popular and time-tested metrics, aka, the science behind market valuations, there’s also a lot of art—aka, the stories behind the stocks. These stories often form the basis for expectations of individual stocks and market performance as much as data-driven metrics.
Metrics matter when investors want to understand corporate potential and to determine the industry or corporate standard or “normal.” But what does “normal” mean when “normal” changes over time? Economies and assets go through cycles and essentially, “normal” is determined by where we are in a cycle. If we’re in a high, a low or midpoint, that helps determine where normal is.
Let’s take a look at metrics and a few prevalent methods of investing and where science and art meet in each.
Metrics of value investing
I’m a huge admirer of Warren Buffett and what he’s brought to investing: he’s helped countless people make sense of the markets and grow lasting wealth because he sticks to a set of metrics that are the basis of value investing.
The goal of value investing is to find publicly traded companies whose stock prices indicate that they’re valued below what they are believed to be worth, as demonstrated by key metrics. First espoused by Benjamin Graham and David Dodd in 1928, it’s the method that Buffet used to build Berkshire Hathaway into a decades-long story of phenomenal growth and success.
As Investopedia defines it: “Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively ferret out stocks they think the stock market is underestimating. They believe that the market overreacts to good and bad news, resulting in stock price movements that do not correspond to a company’s long-term fundamentals. The overreaction offers an opportunity to profit by buying stocks at discounted prices—on sale.”
Good to know. But what are the fundamental metrics on which value investors identify those potentially underestimated stocks? They include both qualitative and quantitative evaluations of a company’s performance, as well as its position compared to its industry. Qualitative information includes subjective evaluation of long-term growth potential and management experience and vision. Quantitative measures include:
SOURCE: Corporate Finance Institute
Assets and liabilities
Revenue
Profitability
Market share
Price-to-sales ratios
Price-to-earnings ratios (the amount you need to invest in a company to gain one dollar in earnings, demonstrated as “share price divided by earnings per share”); this can be used to determine whether a company is undervalued or overvalued, as well as where it stands in comparison to its industry (here’s a simple illustration from the Corporate Finance Institute that shows how a stock that may be less expensive to buy may not be a better value, based on this one metric):
SOURCE: Business Insider, “Warren Buffett’s favorite market indicator soars to record high, signaling stocks are overvalued and a crash may be coming,” Feb 10, 2021
Keep in mind that these are fundamental and accepted metrics and individual investors often come up with some of their own key criteria before investing. Metrics are imperfect but ultimately they work, especially when they enable investors to make informed decisions about companies and industries that they already know and understand.
Note, too, that metrics can be company- or industry-specific or as broad as economies. For example, and as summarized by Business Insider, the “Buffett Indicator” compares the total value of the stock market to quarterly GDP, gauging whether it’s overvalued or undervalued relative to the size of the economy.” As I write this it’s in record territory, indicating extreme overvaluation:
Growth investing
While value investing looks for undervalued stocks for companies that are considered well-managed with strong long-term potential, growth investing looks for publicly traded companies whose products or industries (or both, usually) represent growth potential, translating to stocks that investors believe will outperform the market overall long term. With this strategy, investors still look at some of the same metrics as value investing.
Why don’t all investors use these strategies and metrics?
It’s fair to say that value and growth investors alike use some or all (and more) of these fundamental measures to evaluate corporate potential and stock value.
Day traders and other investors whose primary goals are rapid returns may use a few typical metrics or none at all and instead, may devise their own metrics and strategies. For these investors, while the ultimate goal—making money—is the same, the time frame becomes extremely compressed into weeks, days, hours or less, even moments. Often, they’re looking to leverage incrementally small changes amplified by volume, so considerations like a company’s long-term potential don’t factor in.
While trading has always been rapid in execution, the availability of technology and trading platforms that make it accessible to all has led to the current amplification of this kind of trading (pandemic-related growth notwithstanding).
How do investors decide on a strategy?
For many people, a preferred strategy will depend on things like risk tolerance and how long an investor intends to hold stocks; often, people will evolve their preferences or combine their approaches over time.
The Balance did a nice comparison—if you’re more of a visual person, here’s one of the illustrations from the post, “The Best Investment Strategies,” by Kent Thune.
I think it’s likely that the current surge in gamification of the markets will live on for some time—perhaps it’s with us forever—because it appeals to a not-insignificant share of investors, including many new investors. Still, I think that the value investing will prevail, because it’s a time-tested method that’s helped millions of people grow their wealth over the longer term.
I also think that with time and experience (and as retirement ages grow nearer), many current “gamification” investors will evolve their preferences to value or growth models as they look for solid yet stable investment returns for the long term.
Does this correlate to residential real estate?
There are a slew of metrics that we look at in housing: months of supply, sales prices, year-over-year increases in volume or prices, normalized returns, new construction, buyers vs. sellers are all among them. And by any metric, housing is clearly overheated.
In this blog and elsewhere, I’ve said that I believe there are correlations between markets and housing. Here’s a development in that arena that I’ll be watching: In commercial real estate markets, real estate that’s considered high risk and/or low value is rated accordingly. When A+/A properties are out of reach for investors financially, they gravitate to the higher risk properties, which are undergoing a relative surge.
And don’t we see a similar thing happening in housing, where people are buying homes in tertiary markets that are typically considered outliers—and subsequently paying record-high prices for these homes?
All of this is predicated by human behaviors: Clearly, there’d be no markets, housing or otherwise, without us, so the metrics we see are ultimately a reflection of human emotions and resulting behaviors.
Is now the right time to invest?
If the markets are overvalued, is now a bad time to invest? In my opinion, no, certainly not, particularly because it’s a relative handful of companies that are pushing the overvaluations, including tech stocks and cryptocurrency and shiny stocks like Tesla. There are still countless stocks that represent good investments by either value or growth principles.
The way I see it, a primary risk now isn’t market bubbles but, rather, the prevalent gambling/gaming mentality. That’s what I believe needs correction, too.
Looking ahead, we know that fuel will be added to the fire when the next round of stimulus funds hit the public. This action is necessary to bring back jobs in the hardest-hit industries. Yes, there will come a financial reckoning sometime and we’ll worry about (and recover from) that another day. Now isn’t the time to pull back.
The stories behind it all may be the most important narrative
Last point for today—when considering stocks, ask who is telling its story. For example:
When Warren Buffett invests I pay attention, knowing that he and his team have done their homework.
When Elon Musk invests I pay attention, knowing that he is a charismatic supergenius who often seems to manipulate the power he has to suit his vision.
For those reasons, any action I might take as a result of the stories they tell might be very different, no matter how much I admire both.
Consider the source: Human nature ensures that the cult of personality can be at least as influential as data and science and so much of investing is about who tells the story.
