Stock Valuation: The Sanity of Institutions

Stock Valuation: The Sanity of Institutions

Most of us find that at least a part (and often all) of our investible funds are in the hands of institutional portfolio managers – those who run the large pension and retirement funds, mutual funds, investment counseling organizations, and the like.

By 1960, institutions and other professional investors accounted for almost half of the total shares traded on the New York Stock Exchange. Two decades later, institutions such as mutual funds or pension funds had come to dominate the market almost completely.

During the late 1980s these organizations generally accounted for 85 percent or more of the trading volume on the New York Stock Exchange. Surely, in a market where professional investors dominate trading, the game must have changed. The hard-headed, sharp-pencilled reasoning of the pros ought to be a guarantee that the extravagant excesses of the past will be avoided.

And yet in 1969 a company with annual sales of only $16 million was “valued” by the market at $1 billion – the latter value being obtained by multiplying the number of shares outstanding by the price per share. Throughout the past thirty years of institutional domination of the market, prices often gyrated more rapidly and by much greater amount than could plausibly be explained by apparent changes in their anticipated intrinsic values.

Sanity of Institutions. Photo by Elena

In 1855, for example, General Electric announced that its scientists had created exact duplicates of the diamond. The market became entranced at once, despite the public acknowledgment that these diamonds were not suitable for sale as gems and that they could not be manufactured cheaply enough for industrial use. Within twenty-four hours, the shares of G.E. rose 4 ¼ points. This increased the total market value of all G.E. shares by almost $400 million, approximately twice the then current value of total worldwide diamond sales and six times the value of all industrial diamond sales. Clearly, the price rise was not due to the worth of the discovery to the company, but rather to the castle building potential this would hold for prospective buyers. Indeed, speculators rushed in so fast to beat the gun that the entire price rise was accomplished in the first minutes of trading during the day following the announcement.

In 1988, Johnson and Johnson announce that one of its relatively minor prescription skin products, Retin-A which had been around for years as an acne medication, might have a much broader market than had previously been imagined. Test results have shown that repeated applications of Retin-A to aging skin could actually remove wrinkles. Immediately following the announcement, Johnson and Johnson’s common stock jumped up in price by $8 a share, thus increasing the market value of the company by approximately $1.5 billion. Even the most optimistic forecasts for Retin-A projected that the product might achieve sales by 1990 of $150 million to $200 million per years. Considering that some dermatologists called the benefits “minimal” and others wondered about long-term side effects, it would appear that the initial market reaction was overdone.

Of course, we should not generalize from isolated instances. Professional investors, however, did participate in several distinct speculative movements from the 1960s through the 1980s. In each case, professional institutions bid actively for stocks not because they felt such stocks were undervalued under the firm-foundation principle, but because they anticipated that some greater fools would take the shares off their hands at even more inflated prices.