Wit, Wisdom, Warren (Issue #3): The Valuation Junkyard

Image Source: Rediff

Last week, I reviewed lessons from Warren Buffett’s 1958 letter to partners of Buffett Partnerships.

Lest you forget, here is a summary of the key lessons we discussed in that review:

1. In rising markets, there’s a rise in the ratio of mercurially tempered people – those with rapid and unpredictable changeableness of mood. The overall mood is of exuberance. People invest in stocks for any and every reason. These combine together to further stimulate rising stock prices. Whenever you find such a deadly combination next time, simply run for cover…because such exuberance will always leads to eventual trouble – stock market crashes.
2. Be very careful while buying illiquid stocks – The impact cost of a large sell order can be huge in case the stock surges and a large investor wants to cash out.
3. Illiquidity of a great stock can work to your advantage as a small investor. You can buy it over a period of time without impacting the price materially. Then, when big investors come to know the story and take a bite of it, you would’ve already made your money.
4. Avoid extrapolating short term performance into long term performance. A 30-40% return from your stocks in one year doesn’t mean you will retire a rich investor in 10 years. It never happens!
5. Use intrinsic value as a reference point to sell stocks – Sell when a stock reaches close to intrinsic value, and also when intrinsic value reaches close to stock price.
6. Sell a stock (but only when you don’t have any investible cash left) if you can find a better opportunity – one with a greater margin of safety.
7. Beware of permanent loss of capital…and then when you identify businesses that won’t impair your capital permanently, buy them and be willing to wait for even 10-15 years to create tremendous wealth from them.

Today, I review the letter for 1959.

Conservatism versus permanent loss of capital
After a good 1958, the US stock market as represented by the Dow Jones Industrial Average (DJIA) had another good year in 1959. Including dividends, the DJIA rose by almost 20% during the year (over a 39% rise in 1958).

Buffett’s six partnership (up from five in 1958) gained between 22% and 33%, thereby again outperforming the broader market by a decent margin.

In the 1959 letter, Buffett reiterated his apprehensions about the sharp rise in stock prices in 1959, as he had done in 1958. He wrote…

Most of you know I have been very apprehensive about general stock market levels for several years. To date, this caution has been unnecessary. By previous standards, the present level of “blue chip” security prices contains a substantial speculative component with a corresponding risk of loss.

Perhaps other standards of valuation are evolving which will permanently replace the old standard. I don’t think so. I may very well be wrong; however, I would rather sustain the penalties resulting from over-conservatism than face the consequences of error, perhaps with permanent capital loss, resulting from the adoption of a “New Era” philosophy where trees really do grow to the sky.

Buffett hinted at a large amount of speculative component in valuation of US blue-chip stocks after the rise over the previous few years.

He also pointed to “other standards of valuation” that had evolved during the bull-run that investors were using to justify higher stock prices.

But Buffett rubbished these new valuation methods that were a product of the bull market. He maintained his intrinsic belief in the old standards of valuations that he had been taught by his master, Benjamin Graham.

What Buffett mentioned is true of all bull markets, where traditional and sensible methods of valuing stocks (like DCF and EPV) are all relegated to the trash bin while analysts and investors take up on new, exquisite valuation models.

Let’s study this from the Indian stock market’s perspective.

Harshad Mehta’s “replacement cost” junk
If you were an investor during the Harshad Mehta days (I have a faint memory of my uncles losing a lot of money then), people had started valuing cement stocks at replacement cost, led by the ‘big bull’ himself.

Mehta got particularly bullish on ACC, whose price he bid up to Rs 10,000 (Rs 341 as per today’s adjusted shares outstanding). His theory basically argued that old companies should be valued on the basis of the amount of money which would be required to create another such company.

The problem was that he extended this theory to such obscene heights, and that investors followed him with such dedication, that stocks were getting valued at way beyond their replacement costs.

Dotcom boom’s “eyeball” valuations
History repeated again in 1999-2001, which belonged to a new breed of companies known as TMT (technology, media and telecom) or ICE (infotech, communication and entertainment).

This time, analysts and investors were valuing these companies on a funny metric called “eyeballs”!

A dotcom company got listed on day one, people thought it was the “next big thing” on day two, they projected the number of “eyeballs” on the company’s website and thus its sales and profits to beat all benchmarks on day three, then gave it a P/E multiple of over 100x on day four, and then a new crop of people joined in, pushing the stock price to even higher limits.

Such were the speculative instincts during the dotcom boom. The “adoption of a New Era philosophy where trees really do grow to the sky”, something that Buffett talked about in 1959, was true of the dotcom boom as well.

This is another proof that in stock market, the history does not repeat, it rhymes.

Anyways, I searched Google for some expert opinions on Indian markets during the peak of the boom, and here is what I found from Dec. 1999, four months before the market’s peak then…

The chief investment officer of Alliance Capital AMC, Samir Arora, said the investment outlook for India was very bullish in the next 18 months.

Alliance Equity Fund has given a annualised return of 144.2 per cent till November 30, 1999. The fund was launched in August last year. As on November 30, the fund has assets of Rs 354.4 crore. The top ten stocks include Satyam, Infosys, Zee, Global Tele-Systems, HFCL, Larsen & Toubro, Digital Equipment, Software Solution, Citicorp and HDFC Bank. (Source)

Here is something I read today of that boom as to what some international experts were predicting then…

March 1999: Harry S. Dent, author of “The Roaring 2000s.” “There has been a paradigm shift. The New Economy arrived, this time really is different.”

October 1999: James Glassman, author, “Dow 36,000.” “What is dangerous is for Americans not to be in the market. We’re going to reach a point where stocks are correctly priced … it’s not a bubble … The stock market is undervalued.”

August 1999: Charles Kadlec, author, “Dow 100,000.” “The DJIA will reach 100,000 in 2020 after “two decades of above-average economic growth with price stability.”

December 1999: Joseph Battipaglia, market analyst. “Some fear a burst Internet bubble, but our analysis shows that Internet companies … carry expected long-term growth rates twice other rapidly growing segments within tech.”

February 2000: Larry Kudlow, CNBC host. “This correction will run its course until the middle of the year. Then things will pick up again, because not even Greenspan can stop the Internet economy.”

November 2000: Louis Rukeyser on CNN. “Over the next year or two the market will be higher, and I know over the next five to 10 years it will be higher.”

December 2000: Alan Greenspan. “The three- to five-year earnings projections of more than a thousand analysts … have generally held firm. Such expectations, should they persist, bode well for continued capital deepening and sustained growth.”

March 2001: Maria Bartiromo, CNBC anchor. “The individual out there is actually not throwing money at things that they do not understand, and is actually using the news and using the information out there to make smart decisions.”

August 2001: Lou Dobbs, CNN. “Let me make it very clear. I’m a bull, on the market, on the economy. And let me repeat, I am a bull.”

Note: The Dow didn’t bottom until October 2002 at 7,286, down from 11,722.

PEGged in 2006-08
No lessons were taken from the 2000 bust. The story repeated again in 2006-08, when different experts with different names appeared all over to lend their advice on the future of stock markets.

This time, trees were expected to grow to the sky based on newer valuation methods – land bank valuation and sum-of-parts valuation were just a couple of them.

The PEG (or price to earnings growth) was also in focus, as analysts justified superlative P/E ratios of realty, power, consumption, retail, and all other kind of stocks.

They reasoned that P/Es were still lower then (2006-08), given the high “expected” earning growth rates for companies over the next few quarters and years.

Like on 18th December 2007, after the Sensex dropped by 1,200 points over a 4-day period, a newspaper reported…

“Today was the continuation of yesterday weakness, but the markets didn’t crash like yesterday as there was value buying, mainly by domestic retail investors,” Ambareesh Baliga, vice president of Karvy Stock Securities said.

“Value buying” at a Sensex P/E of 26x? Something was definitely wrong!

Here are some other “tree can grow to skies” predictions from that period…

“India is the best bull market in Asia,” said Chris Wood, global strategist at brokerage CLSA, which has a long-term Sensex target of 40,000.

“India is at an inflexion point, there is a re-rating of the market,” said Amitabh Chakraborty, equities chief at Mumbai’s Religare Securities, who dismisses talk of a “bubble”.

“Over a three-year horizon, we see a 30,000 target as very believable.”

“We might see some consolidation but I don’t think there is an event out there that will derail the market. The economic fundamentals are sound,” said Andrew Holland, strategic investment managing director at Merrill Lynch in India.

”The market will continue its secular upward trajectory, reflecting robust economic growth led by consumption-buoyed demand, favourable demographics and increasing infrastructure spends,’ the Hindustan Times quoted Anil Advani, head of research at SBI Cap Securities, as saying.

A spokesperson for foreign brokerage HSBC, which has put a Sensex target of 23,000 for 2008-end, said, “The Indian markets will retain their appeal to global investors; it is an outstanding domestic story, led by consumption and capex, in an uncertain world.”

In a survey conducted by the Federation of Indian Chambers of Commerce and Industry, 55 per cent of the respondents, comprised of stock brokers and money managers, predicted the market level to reach 25,000 points and above at the end of two years.

First Global Securities head Shankar Sharma, early this month, said he will not be surprised if the index touches 25,000 to 30,000 in the next 12 months or so.

Now, please stop laughing!
In hindsight, we may be laughing at these predictions and casting doubts on the intelligence of these experts, which is fine.

But how many of us were having a contrarian view then? Along with these experts, didn’t you also believe in the continuation of the “India growth story” and the “India decoupling story”?

Yours truly, who, till 2008, had only seen a bull market ever since he “joined” the stock market in 2003 (when the bull-run started), wasn’t hibernating somewhere.

Despite remaining somewhat out of the frenzy given a “relatively” saner brain inside my head (believe me please! :-)), I was still recommending “hold” on stocks that I believed were “expensive but not so much due to the strong future growth prospects”.

So for every “sell” recommendation (like Reliance Communication, Reliance Power, Suzlon), I had two “hold recommendations (like BHEL, Crompton Greaves, GE Shipping, ABB).

Everything crashed in the bust that followed, and all target prices based on “strong growth prospects” were diffused.

Luckily, my hatred for Reliance Group stocks, real estate stocks, green energy stocks, and all other “hot stories” was as valid then as it is now, but I still was not able to see the situation getting as bad it eventually got.

I was also lucky to have sold off all my stocks near the end of 2007 to pay off a part of my home loan and end my car loan. But then, I was happy to put 100% of my new savings into the stock market via mutual funds.

The crash of 2008 has changed a lot in me as an analyst and investor. I’ve become a lot-lot conservative now in my analysis and valuations, simply because as Buffett wrote in the 1959 letter…

I would rather sustain the penalties resulting from over-conservatism than face the consequences of error, perhaps with permanent capital loss, resulting from the adoption of a “New Era” philosophy where trees really do grow to the sky.

Are you a conservative investor?
Conservatism, while being painful when stocks all around are rising, pays off well in the long run.

This is because when you are conservative, you give a lot of importance to the concept of ‘margin of safety’, and thus end up with fewer heartaches and even fewer heart attacks than most other reckless investors.

Conservatism is not same as being contrarian 100% of time. It means being contrarian in times of extreme fear or frenzy, but only after doing diligent and rational analysis of stocks and after assuming a sufficient margin of safety.

In simpler words, conservatism means expecting your tree to “not” grow till the sky, not even if the neighbouring trees are growing to that height…because one day, they will all come crashing down.

In that sense, are you a conservative investor?

Key ideas from Buffett’s 1959 letter
Here is a summary of the key ideas we discussed in this review of Buffett’s 1959 letter to partners:

1. Become apprehensive of investing in stock markets when you hear new valuation metrics being used by analysts and other investors to justify rising (and even higher) stock prices.
2. Don’t change your investment, and especially valuation, philosophy just because stock prices are rising. Traditional intrinsic valuation methods like DCF, EPV, and Graham’s rule will still give you reasonable answers. However, always expect yourself to go wrong with your intrinsic valuation estimates. Be that humble!
3. In rising markets, a large component of the valuation in most stocks, even blue chips, is “speculation”.
4. Be conservative in your investment thought process and analysis. Be willing to sustain the penalties resulting from over-conservatism than face the consequences of error, perhaps with permanent capital loss.
5. Trees never grow to the sky, not even in the stock market.

This was my review of Buffett’s 1959 letter to partners. Let me know if I missed any lesson that you found out through your personal reading of the letter.

Next Friday, I will review Buffett’s 1960 letter to partners, which you can read here.

• Archives of Wit, Wisdom, Warren