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Quentin Dupont, S.J.December 04, 2013

In their widely cited book Securities Analysis, co-authors Benjamin Graham and David Dodd introduce what they call the “value investing” method. “Without some defined standards of value for judging whether securities are over- or under priced in the market place,” they write, “the analyst is a potential victim of the tides of pessimism and euphoria which sweep the securities market.” To counteract these tides, Graham and Dodd emphasize the importance of facts, “the value which is justified by assets, earnings, dividends, definite prospects, and the factor of management.”

Graham and Dodd’s approach has had a proven record: billionaire Warren Buffet, “the Oracle of Omaha,” has repeatedly credited his success on the stock market to Graham’s principles, which Buffet first encountered as a student of Graham’s at Columbia University’s business school in the early 1950s. However, other investors have made fortunes on their own sets of principles, and Graham’s way does not guarantee success: Buffet’s worst investing performance came at the height of the tech boom, while everyone else seemed to make money hands over fists.

In recent years, tech companies have recovered some luster from their fall in the burst of the “dot com” era at the beginning of the third millennium. This resurgence has manifested itself in part through the wave of tech initial public offerings over the past few years. Twitter (TWTR)’s public offering was launched amid full fanfare last month. Other tech companies, such as the electric carmaker Tesla Motors (TSLA), jumped on the stock market trading floors a few years ago. At the core of Graham and Dodd’s method lies the science (or according to some, art) of valuation. This exercise is a difficult one when it comes to innovative business models, as I will show below. It also requires an understanding of the dynamics both within the firm and beyond it. As we will see, value investing is firmly rooted in the investor’s values.

The Return of Tech Stocks

Twitter’s first days of trading on the New York Stock Exchange have reminded many commentators of the heyday of the “dot com” era, and caused some to wonder whether the valuation bubble is back. After all, how can a firm with zero profits (current earnings per share stand at negative 20 cents according to Yahoo! Finance), no dividends in sight and a rather young management team command an initial price of $26 per share and be currently valued around $41 for a market capitalization of around $22 billion? Twitter’s management points to the company’s size, growing influence and increased revenues from advertising as a solid ground for prospective financial gain. As financial tautologies go, there are few things riskier than projecting future earnings based on past performance; yet, with investing, there’s little else to work with. We thus always deal with varying degrees of risk and with investors’ responses to such uncertainty. In Twitter’s case, investors are clearly optimistic about its future, betting on massive profits to come. So is tech back to stay?

“High tech” has certainly broadened its footprint in our world. In 2000, the car industry would have almost exclusively been labeled “low tech.” After all, it was based on 19th century technology: the internal combustion engine. Even with airbags, CD players and navigation systems, cars were a product of “industrial America.” Enter the boom of hybrid engine cars, and now all-electric cars such as Tesla’s Model S. Of course, most of the electric energy that “plug in” cars run on is produced by the usual means (i.e., fossil fuels). Yet these cars are presented as a new technology, and are designed and advertised to let you feel the hype and excitement. Tesla, arguably the flagship of these new generations of cars, also rides the optimistic tech wave: though the company is losing $1.95 for each share, its overall value stands north of $15 billion as of this writing.

Both Twitter and Tesla’s stocks have enjoyed some significant swings in value and trading volume in the last few weeks. (In the time it took me to research and write this article, Twitter lost about 6.5 percent and Tesla about shed over 10 percent of its value, but the latter is fighting its way back as I write.) Tech stocks have usually fed on volatility. They are usually considered “growth” stocks: stocks that have high potential in price movements, as opposed to “value” stocks, which have more stable prices but often reward investors with dividends.

However, Tesla and Twitter are not strictly comparable, even within the high tech world. Tesla sells hardware. Unlike social networking, the car business requires a lot of heavy investment, but the nature of the product sold allows Tesla to present investors with metrics they are comfortable with: number of units ordered and delivered, cost of good sold, profit margins, etc. This makes Tesla’s business model one that is more familiar to most investors, and thus easier to project. It also makes Tesla more vulnerable to the reality of selling products: over the past months, Tesla’s stock price has suffered from the news of several Tesla car fires prompted by road debris. (A federal investigation on the matter was announced on November 19.)

As for Twitter, the company’s management makes it clear that their business model is centered on advertising. This model has been a popular one for internet-based companies. However, popularity does not necessarily make for sound reasoning, as the rapid crash of some of the dot-com darlings of 2000 has shown. It is a lot easier to analyze profits from the sale of a tangible good or a transactional service than it is to measure the dollar-value impact of advertising, views or clicks. A recent article about a Twitter valuation exercise at the University of Pennsylvania’s Wharton School of Business made this problem clear:

Valuations of Twitter by [Wharton School Professor Luke] Taylor’s students ranged from $500 million to $33.7 billion, showing how difficult it is to gauge a company that has no history of earnings reports and a business model that remains largely unproven. “This is an art, not a science,” Taylor notes. “Even forecasting revenue out for five years is incredibly difficult.”

Indeed, the inherent difficulty of asset valuation is measuring and predicting. But some measures of value are more readily accessible than others, and not all valuations are equal.

Financial valuations depend on assumptions and data analysis rather than on merely reading financial statements. The fall of Enron in 2001 taught us that it may be easier to cheat on financial reporting that we originally thought. On the other hand, qualitative factors cannot be ignored: the formidable rise of Apple during the years of Steve Jobs’ return to the company, and its much more tepid course since his death, shows how much company-generated excitement and avant-garde marketing can accomplish. In other words, valuation is not only about the numbers in the financial statements, but also about what surrounds them. In that regard, launching a public offering for a profit-less company may not be always and everywhere financially inappropriate. But, when the company’s business model is itself volatile (selling old fashion hardware while betting on a new way to make the product; pitching a social media site which depends on the popularity of a wave-riding young public) or hard to translate into dollars (what’s the dollar value of a user viewing an ad?), it may add an impenetrable layer of complexity with respect to the predictability of future success.

Value and Values

Deep down, the question of a company’s value depends precisely on the assumptions that are attached to it: how are revenues expected to behave? What about expenses? How is the greater economic landscape impacting this stock? Some of variables at play in these assumptions impact a certain company more directly than another. (For example, a change in the Federal Reserve’s main interest rate will likely impact banks and industrial companies differently.) Other variables may be implicit or need to be discovered (for example, the role, size and use of a company’s off-balance sheet entities). Graham and Dodd’s masterwork exemplifies a standard method to approach such questions. But not all analysts succeed, because there is also a lot of “flair,” creative investigating and assumption-based deductions at play in the process of assessing a company’s value.

Underlying all these assumptions and variables, then, one finds a system of values. The most recently awarded Nobel Prize in Economics made it clear that these value systems can be drastically different, even in the same class of Nobel laureates. Eugene Fama, of the University of Chicago, is a proponent of something called the efficient market hypothesis, which basically states that market prices reflect rational behavior. Robert Shiller, who teaches at Yale University, belongs to the school of behavioral economics, which has shown that psychological biases cloud our judgment and lead us to non-optimal decision-making, and thus prices reflect partly irrational behavior. These views of how markets (or really, agents on the market) behave stem from different views of the (financial) world, that is, of different value systems.

This, in turn, prompts those of us who invest in financial instruments, or who hire others to invest for us, to wonder: what is our value system? How do our values inform our investments? Last month, the Wall Street Journal published an article called “Investing as a Religious Practice.” The article mentioned several companies using religious belief, including some funds using Catholic social doctrine, as a value system to guide their investments. What does this have to do with Twitter and Tesla? These companies’ business models are based on a certain value system on which their profit prospects and stock valuations are based. For Tesla, the “pitch” is about electric cars’ carbon emissions reduction and reduced energy costs. (Critics wonder about the source for the energy that fuels the car’s battery and how to discard these batteries at the end of the car’s life cycle.) For Twitter, money is advertising. This may lead us to wonder about the extent of our participation in a society fueled by consumerism: of objects, of information, even of relationships. Behind a stock, there is a story. Behind a value, lie values.

I do not intend to demonize hybrid car buyers (I have done my share of Prius-driving as a member of various Jesuit communities), or social networking (I am a Facebook user and a contributor to The Jesuit Post). Still, there is a conversation to be had about all of this. Because, in the end, the exercise of stock valuation leads us to discuss our assumptions, and to have a good look at our personal and societal value systems. St. Ignatius of Loyola famously spoke of “finding God in all things.” We may not need to find God in all stocks, but we do need to see how the life God calls us to live as committed Christians reflects on all that the world is composed of, including our investment decisions.

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John Walton
8 years 5 months ago
The "efficient market hypothesis" does NOT state that market prices reflect rational behavior. It states that at any point in time the price of a security reflects all of the information currently available. Information changes.
Quentin Dupont
8 years 4 months ago
Dear Mr. Walton, thank you for your precision regarding the (semi strong form) definition of the EMH. The relationship between efficient market and agent rationality indeed happens through the link between information and prices, the latter reflecting agents' actions prompted by the former. And yes, information changes and thus price changes, or to quote the classic Bodie, Kane & Marcus's textbook on Investments' description of the research on market efficiency: "It soon became apparent that random price movements indicated a well-functioning or efficient market, not an irrational one" (6th Ed., 2005, p. 370--for the relationship between randomness and efficiency, please consult Burton Makliel's "A Random Walk Down Wall Street"). Indeed, the EMH stems from the findings that "prices are determined rationally" (Bodie, Kane & Markus p.371). Prices, however, move because of agents' actions (basically, buying or selling). Hence rational price determination stems from rational agency on the part of market participants: information is rationally priced in the asset. This is a short way to describe what Robert Shiller refers to as "rational expectations models" based on the EMH (See: Robert Shiller : "From Efficient Market Theory to Behavioral Finance", Cowles Foundation Discussion Paper 1385 p.3 http://cowles.econ.yale.edu/P/cd/d13b/d1385.pdf ). The link between rationality and efficient market theory is thus one shared by many prominent Finance scholars. I hope this comment helps you see how I came about relating efficient market theory and investors' rationality. Thank you for your interest in America.

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