Commentary by Dr. James McCann, Chief Scientist, Plotinus Asset Management
One hardly needs to complete the quotation from Lady Windermere’s Fan, it is so well-known. Context is everything, however, and Wilde, through Lord Darlington, was defining a cynic as “a man who knows the price of everything and the value of nothing.”
In the 1880s the idea that the financialization of everything from art and ethics to music and dance seemed absurd. As a leading light of the aesthetic movement Oscar Fingal O’Flahertie Wills Wilde would be shocked, but not surprised at the penury in the creative arts compared to the well-heeled “cynics” in the financial centers.
Fundamentally, Wilde had hit on a truism about reconciling price and value. Let’s make a stab at defining value in terms of stock in a company. The price of the stock defines the market capitalization of the company: number of stocks times the price per stock. However, the value of the company could be defined as a combination of the net asset value and future returns. That is, the company’s assets minus debts plus the (discounted) cash flows from future dividends.
Relative value is a reflection of relative price, but while price is known, value remains elusive.
There’s the rub. One has no idea of the value of future dividends, nor the hypothetical future price. Suppose there is some mysterious target price to which the market converges: the famous “reversion to the mean” postulate. This target price is based on company “fundamentals” derived from the annual accounts, for example. The “fundamental investor” takes a strategic approach, by this I mean medium- or long-term goals, based on timescales of several years. While a fundamental approach adapts to the market conditions, it disdains short-term trends, precisely because it smooths over the seasonal caprices of cash flow.
The flaw in this approach is calibration. The valuations of the market tend to be “relative,” rather than “absolute.” That is the accounts of comparator companies can be analyzed to determine which is higher and which is lower in value. And by iteration, every company is peer-reviewed and ranked by market investors. That is, the relative value is a reflection of relative price, but while price is known, value remains elusive. Worse than that, the investor doesn’t give two hoots, so long as the stock increases in value and keeps paying healthy dividends!
A similar process applies to bond pricing, in which the credit rating of a company is, in principle, based on the intrinsic value and capacity to repay the bond. One can create models calibrated on historical default data. But a great deal of the calculation is based on where the data is most abundant. The weight of evidence has a strong influence in statistical models. Thus, judging value of companies that differ from the norm is problematic. One often simply extrapolates into the darkness and this determines the bond price of the respective company.
But the default probability within such models depends on the value of the company—which we don’t know! The remedy to this conundrum is the magical efficient market, in which price is a proxy for value. But if the market lacks the knowledge to make a sensible value-based price, which is the reality by the way, then we are in a muddle. And while this perplexes the well-heeled cynics of Wall Street, Wilde gives an illuminating perspective of who really loses sleep over such problems: “There is only one class in the community that thinks more about money than the rich, and that is the poor. The poor can think of nothing else.” ■
July 2021
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