By John Husselbee, Head of the Liontrust Multi-Asset team at Liontrust Asset Management
Growing fears about rapidly inflating bubbles in certain parts of investment markets have led to renewed focus on one of the oldest – and most fundamentally misunderstood – relationships in finance, between price and value.
Warren Buffet’s ‘price is what you pay, value is what you get’ is a favoured quote to illuminate this and we are also reminded of the Oscar Wilde character knowing ‘the price of everything and the value of nothing’. The retort to this is the even better but less well-known, ‘a sentimentalist…is a man who sees an absurd value in everything and doesn’t know the market price of any single thing’.
When it comes to most publicly traded assets, operating without the safety net of a recommended retail price, there is a difference between what something is ‘worth’ based on its fundamentals and how much people are prepared to pay for it. This means it is possible to get bargains from time to time (think of investment trusts trading on a discount, for example) but this disconnect has also fuelled every bubble in history, from the 17th century’s tulip mania through the late 1990s’ technology bubble to the frenzied trading in assets such as Bitcoin and stocks like GameStop and Tesla in recent months.
Going right back to first investment principles, the value of an asset is determined by its fundamental properties. With equities, for example, this includes its assets and liabilities, earnings, market share, management team, and, for investors, its capacity to provide cashflows over time. There are a huge range of metrics to indicate underlying value, often combining these properties, with the most popular including price to earnings ratio, price to book and debt to equity.
Price, while encompassing those fundamental elements, is also heavily influenced by far shorter-term, sentiment-driven factors, from basic supply and demand (where current fads and fashions come into play in bidding up or pulling down prices) to market noise, whether macro, micro or simply the prevailing news headlines of the day.
Most investors understand this trade off and, for the most part, longer-term fundamental factors are reflected in valuations. But there are also times when the value/price spread becomes more than simply attributable to short-term noise and bubbles emerge, with Tesla providing a perfect case study of this.
If you look at Tesla’s price to book ratio, it was already expensive in 2018 and 2019 at around 12 times but this ballooned last year to over 40, while rival car firm Ford, in comparison, has remained stable at around one times book value. Tesla fans may try to rationalise this with claims the company is at the vanguard of an electronic revolution in the car world, and they may be proved right. But if you just focus on the here and now, Tesla’s 700%-plus share price appreciation during 2020 looks very hard to justify: the company sold just 235,000 cars in its home market (the US) last year (versus close to two million for Ford) while its market cap expanded from $75 billion to $668 billion.
For anyone wanting to invest at these multiples, they have to question what value they are getting for their money and, for shareholders, this will ultimately be determined by how far Tesla can keep rising. We harbour serious doubts about stretched valuations across several tech companies in the US and believe recent corrections could continue through this year and beyond.
Theoretically, keeping the above factors in mind should help investors from overpaying for assets, particularly in periods of volatility and overexuberance, but as any student of markets knows, fear and greed continue to dominate decision making and even the most experienced still try to time the market. In a recent paper, behavioural finance expert Oxford Risk claims that so-called emotional investing has hit a new peak in the current economic, fiscal and market environment; on average, these ill-timed decisions cost investors around 3% in lost returns a year over the long term and this figure is rising amid the current crisis.
Emotional responses to short-term market noise typically push people into buying high and selling low and they frequently pursue investments that are familiar – companies publicised in the media, for example, and those that have recently announced large gains. According to Oxford Risk, this is because, in times of stress, investors find comfort in names they hear about regularly that seem to offer the promise of short-term returns. In financial terms, as in many other parts of life, Covid-19 has left many people highly sensitive and with a shortened emotional time horizon, which increases and explains the appeal of investments that are little more than get-rich-quick gambles.
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