In the United States during the 60s and 70s there was a group of stocks labeled “The Nifty 50”. They were blue chip stocks whose underlying companies were purported to be bulletproof. These were stocks that couldn’t go down and had consistent earnings and growth over long periods of time. There was a frenzy of optimism surrounding them, investors small and large were buying as many shares as they could manage with the belief that they couldn’t pay too high of a price. Consequently, the price to earnings ratio (P/E ratio) of The Nifty 50 skyrocketed with valuations that quickly became unrealistic. Eventually, the prices became so inflated that the stocks in The Nifty Fifty plummeted in valued. The bubble of optimism surrounding the companies was popped by the reality that every company has a finite value and you can pay too high of a price, even for a great asset.
So What’s it Really Worth?
This takes us to the title of today’s blog, “How Much Optimism is Factored into the Price?”. This quote comes from Howard Marks, an investor who runs one of the largest investment firms in the U.S. managing well over 100 billion in assets. As alluded to in his quote, investors often buy assets (real estate, stocks, etc.) on the belief that it will go up as opposed to buying based on what it’s actually worth. Novice investors hear about a burgeoning real estate market and flock to buy property at any price or are given an “insider tip” about a company and hurriedly buy their stock, regardless of the price. This leads to fear of missing out (FOMO) from other (novice) investors who then proceed to buy which drives the price up and up, well past realistic levels. This frenzy of optimism leads to a bubble that eventually bursts (for additional reference, see The South Sea/Mississippi Bubbles, The Dutch Tulip Bubble, or the more recent Bitcoin Bubble) causing many investors to lose substantial amounts of money. Bubbles such as these arise from an unrealistic amount of optimism among investors which leads to assumptions about the future which is ultimately unknowable.
Intrinsic Value
When looking at any investment, it’s important to focus on its intrinsic value. Intrinsic value is a mathematical determination of what an asset is really worth based on a number of financial metrics. For example, when valuing commercial apartment buildings the formula to determine the asset’s intrinsic value is calculated by dividing the property’s NOI by the cap rate (See our prior blog on Real Estate Valuations). This is an extremely simple, mathematical way to determine exactly what the apartment complex is worth. However, one look at the current market conditions and you will see many investors purchasing apartment complexes at prices that are based on assumptions about future performance/appreciation, not on current performance. Nobody knows the future, which means purchasing assets of any kind based on assumptions about the future will often lead to failure and the loss of capital. For this reason, it’s essential that you wade through the optimism factored into the price and figure out exactly what the intrinsic value is when deciding what to offer on an asset.
Buying at a discount
The aforementioned discussion on The Nifty Fifty and intrinsic value highlight one of the key points of this article, just because an asset is considered high quality, does not mean that it will increase in value forever and you CAN pay too much for it. What’s important when investing is the price you pay versus the asset’s intrinsic value. If you’re able to purchase a stock or piece of real estate for significantly less than what it’s actually worth, then you have found yourself a good deal. Using real estate as an example, the old mantra is that you make money when you buy. This saying highlights the importance of buying at a good price (i.e. below market value) rather than focusing on the quality of the property you buy. There are NO assets of such high quality that they cannot be overvalued. There are FEW assets of such low quality that they cannot be undervalued.
Emotion Vs Reason
Ultimately, the ability to look at a potential investment’s intrinsic value and not allow optimism to skew your perception of its value comes down to thinking with reason and not emotion. On paper, this seems easy to do and we all think we’re logical and driven by facts only. In fact, there are entire economic theories derived from the assumption that investors are rational, even-keeled pragmatists who only think in numbers and reason (see the efficient market hypothesis). However, history has shown us time and time again that this is certainly not the case and investors are prone to frenzies of optimism and irrationality.
Everything is Cyclical
In the late 1990s when the internet was burgeoning and eCommerce was in its nascent stage, everyone could see that conducting business online was the wave of the future. Consequently, investors became overly optimistic about technology stocks involved in online retail and assumed that they could not pay too high of a price for them. P/E ratios for tech stocks shot up through the roof and investors who didn’t initially buy into the craze began to get FOMO which eventually prompted many of them to buy at a high price since they were optimistic about future performance. Shortly after the turn of the millennia, the “dot com bubble” (as it was later called) burst and many investors lost all of their money.
Frenzies of optimism such as this often start when a new technology is discovered (eCommerce, Blockchain, etc.) and financial “experts” start proclaiming the classic phrase “this time is different”. It’s never different, assets will always have finite prices and nothing has a value of infinity. The more optimistic your fellow investors and pundits are about an asset then the more prudence you must conduct yourself with.
Signs of a Bubble
It’s hard to know exactly when prices have gone too far past intrinsic value and when a correction will occur as sometimes assets’ valuations exceed their real value significantly before there is a dramatic drop in price. However, there are several signs that you can pay attention for that are indicative of the fact that a bubble is imminent. Are interests rates absurdly low? Is hard money available at rates that are not far from what traditional lenders previously charged? Are lending standards so loose that nearly anyone can get a loan? If so, this means there is an overabundance of capital looking for yield which is a concerning sign. When rates are too low and investors are unable to obtain meaningful returns from low-risk investments (i.e. treasury bonds) they begin investing in riskier assets just to receive the returns they were previously getting from lower-risk investments. They begin to overlook the risk and hold an exceptionally optimistic view about the performance of risky assets which they previously would have been hesitant to invest in. This type of environment is a strong sign that you may be nearing a market correction.
As previously mentioned, emotional frenzies of optimism surrounding new technologies are also a sign that a correction may be coming. You’ll likely hear the proclamation that the rules have changed (i.e. this time is different) which is another strong sign that a recession is near. At the end of the day, when people start ignoring assets’ intrinsic value and start to behave as if they know the future then the savvy investor should take caution. Again, financial frenzies can go on longer than expected and valuations can dramatically exceed intrinsic value before a correction takes place. You cannot predict when downturns will occur. However, you can act more conservatively and ask yourself “how much optimism is factored into the price” when purchasing to be sure that you only buy based on intrinsic value!
