Investors spend a great deal of time thinking, writing and talking about the fair or intrinsic value of equities, whether it be an entire market or individual company. This is a critical issue. There is probably no greater determinant of the long-run returns we make than the price that we pay. The obvious challenge is ascertaining what fair value is – how do we estimate the current worth of cash flows we expect to receive in the future?  If this task is not difficult enough, there is another problem. Even if we knew the fair value, what would we do about it?  There is no reason to expect that equities should be fairly valued today or tomorrow.

When we discuss equities being cheap or expensive the underlying view often seems to be that at some point ‘the market’ will identify this anomaly, creating the opportunity to profit from a revaluation. The glaring assumption here is that the majority of participants are interested in the same thing. It presumes that most investors are engaged in an effort to calculate the fair value of an asset, they are just coming up with different answers. This is some distance from reality. Investors have a multitude of motives, approaches, and philosophies, many of them with a time horizon far shorter than one which would make defining fair value relevant.   

Wisdom of Crowds

It is easy to think about equity market pricing as a wisdom of crowds model, but it is not. In the classic example, individuals guess the weight of an ox, and the average of these are superior to most individual estimates. This idea can be used to claim that equity markets have a similar form of efficiency. Yet this wisdom only emerges if everyone is trying to guess the same thing. If, instead, some participants guess the weight of a pig, some a sheep and others a cow, the average would not be that useful in gauging the weight of an ox.  

This is the situation for equities. It is not that investors are using identical information but coming up with different answers; it is that they are using information for entirely different purposes. If investors are making decisions based on price momentum, multiple expansion, monetary policy, fiscal stimulus or simply adopting a passive approach, why should the assets in question be priced at their fair value?

The same applies to time. If we are focused on outcomes over one week, one month or one year, what is the relevance of the long-run valuation? If investors are investing for different reasons and with varied horizons, why should equities be fairly valued?

When Valuation Matters

This is not an argument that valuations do not matter, but rather there is no reason to believe that they will matter on any given day, nor is there a constant search by the market to discover fair value. It is best to think of valuations as having a weak gravitational pull over asset prices. Prices will fluctuate through time as cycles evolve and investors extrapolate. They will happen to pass through fair value at various unpredictable points.  

Considering valuations in this fashion leads to two critical observations. First, is the trite but true point that valuations are not useful in timing investment decisions. Second, is that extremes matter. A weak gravitational pull means that prices can diverge materially from fair value, but not become entirely disconnected.

If most investors are not investing because of fair value considerations, why would valuation exert any influence at all?  Because at extreme prices behaviour will change – for example, at dramatic levels of cheapness in an asset class or security the near-term cash flows will be high enough to attract an increasing number of investors.  Similarly, investors will eventually move away from a staggeringly expensive asset, in favour of competing assets with a more attractive cash flow profile.  

To take an absurd example, if an equity market is trading on 100x earnings and paying a 0.1% dividend yield whereas high quality bonds in the same market yield 4%; this will impact the decision making of investors and companies. This is a gross simplification to make the point that there is an unidentifiable juncture where some form of valuation consideration will start to matter more to more people.

The problem with this idea is that we know neither what fair value is nor what extreme means. We can make an estimate of fair value for any asset, but the range would have to be broad, and we might still be wrong. We can even build a framework for defining an extreme divergence, but this will not help us with timing. If we believe that asset prices are extreme then we are paid to wait for when the price again moves through fair value, but we will have no idea when this might occur. 

Extreme dislocations are meaningful because they account for the noise and uncertainty inherent in estimating a fair value for an asset class. If prices are a great distance even from a fair value assumption with a wide range, we can be more confident of the anomaly. Furthermore, extremes matter because they change the probability of suffering from disappointment and disaster. Very expensive assets are likely to carry a greater risk of the long-run disappointment of low returns, and the short-term disaster of a dramatic, permanent reset in price. 

The Valuation Dilemma

Valuations are vital for long-run investment returns, but there is no reason for an asset class to be fairly valued on or by any specific point. We should be aware of extreme dislocations between price and valuation, but these are not easy to define or time. This presents something of a quandary, so how should investors think about these issues?

– Any notion that the pricing of equity markets is efficient because it represents our best collective guess at its fair value based on the information available is unlikely to be true. Investors are using the information in a multitude of ways often unrelated to any approximation of fair value. That the market is not efficient in this form, does not mean it can be easily exploited however.

– Even if we knew the fair value of equities, there is no reason to believe that they will be priced at that level at any given time.  The market is not ‘attempting’ to find fair value.  We should not wait for other investors to ‘realise’ what fair value is.

– Because we operate with such short time horizons, perceived over or under valuations of an asset class or security are often viewed as an opportunity to participate from mean reversion, but we cannot hope to predict this. The more important element of valuation discrepancies is the ability to secure higher cash flows and reinvest at a higher rate of return and avoid the opposite – low cash flows with lower rates of return. This requires time.

– Buying assets that appear extremely cheap based on some view of fair value should be beneficial (on average) because the rates of return should be high, and we should be confident that prices will not become entirely detached from valuation (but can get pretty close to it).  Taking aggressive and concentrated views, however, based on this belief is always a bad idea.

– The longer our real time horizon the more likely it is that we might benefit from extreme scenarios. If our time horizons are short, notions of fair value are close to meaningless. Not only can we not predict when an asset class might become fairly valued (as there is no reason for it to be), but the higher cash flows that we might benefit from over the long-term, are likely to be overwhelmed by short-term factors such as price performance, momentum, and stories.  The premium for long-term investing exists because it is so difficult to do.

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There is no reason for equities to be fairly valued at any specific moment. Over time they will pass through some fair value range for unpredictable reasons, at unpredictable instances.  Despite this, for long-term investors, valuations are likely to define our outcomes and periods of extremes will create the greatest opportunities and threats.