During one of our recent Investment Policy Committee meetings someone uttered the simple phrase, “Price is not value.” For professional investors, this comment may seem obvious and even self-evident. Later, as I pondered a bit on these four simple words, I realized that most people might struggle with this notion. Let me explain.
In the everyday life of the typical consumer, price EQUALS value. Whenever one buys gasoline, the price one pays represents the value of that gas. Sure, looking around for the cheapest gas in the area may provide some value for the consumer, but in most consumer transactions “price = value” is probably the correct formula. If something appears too expensive, the consumer may conclude that the product does not offer sufficient perceived value for the price. If on the other hand, something is selling well below the norm, the consumer may question the quality of the item. This is probably as close as the consumer ever gets to understanding the price/value concept. We tend to feel more comfortable when we perceive the value of something being close to its price.
Applying this idea the stock market, we find that value is much more important than price. The price of a stock is tangible, certain (at any point in time) and simple. We can easily see the price of a stock and can chart the history of any stock far into the past. The value of a stock, which is ultimately more important than its price, is harder to see. First, there are many ways to measure the value of a stock. This fact alone may confuse the casual observer who may desire one and only one definite way to measure value (we sure crave simplicity, don’t we?). Second, stock valuations can change quite dramatically over time. Why would a stock trading at a price/earnings (P/E – one of the most popular ways to measure value) ratio of 15 times (15x) one day trade at 12x the next? To many this notion of value seems too complex and so they tend to focus solely on price.
Value investing is based on the fact that a stock can, at times, trade at a valuation well below its intrinsic or fair value. Value investors make money by identifying, analyzing and buying this kind of “cheap” stock, with the expectation that the stock will eventually trade at its fair value. Then they sell it. This works well for individual stocks, but what about the market overall?
It’s easy to calculate the P/E of the market by simply adding up all the earnings of the companies in any given index. The chart below shows the P/E trend of the S&P 500 over the last 50 years.
This chart clearly shows that although the S&P 500 is now near its all-time high price, its value is in line with the 50-year average. It also shows how expensive (by value) the market was in 1999 and how cheap it was in 2009. I think it also indicates that value by itself does not give one enough information to trade the market. Imagine someone in 1995 concluding that because the market’s valuation was above the average, they should sell – thus missing the last 5 years of the great tech rally. It also helps explain why those voices telling you sell now just because the market is at an all-time high are missing the point.
In my experience, valuation by itself is never enough to move the market one way or another. When stocks are expensive, the surprises tend to be negative ones. When stocks are cheap, the surprises tend to be positive. When the market is fairly valued, stock selection becomes more important. Stock pickers should love where we are in the market now.
Personally, I am still able to find good value in many stocks in many sectors, giving me confidence that the bull market is more likely to continue than not.