What’s Left of the Firm Foundation?

What’s Left of the Firm Foundation?

A renowned rabbi, whose fame for adjudicating disputes had earned him the reputation of a modern-day Solomon, was asked to settle a long-standing argument between two philosophers. The rabbi listened intently as the first disputant vigorously presented the case. The rabbi reflected on the argument and finally pronounced, “Yes, you are correct.”

Then the second philosopher presented his case with equal vigor and persuasion ad argued eloquently that the first philosopher could not be correct. The rabbi nodded his approval and indicated, “You are correct.” A bystander, somewhat confused by this performance, accosted the rabbi to complain, “You told both philosophers they were right, but their arguments were totally contradictory. They both can’t be correct.” The rabbi needed only a moment to formulate his response: “Yes, you are indeed correct.”

In adjudicating the dispute between the firm-foundation theorists and those who take a castle-in-the-aire view of the stock market, we can feel like the accommodating rabbi. It seems clear that so-called fundamental considerations do have a profound influence on market prices. We have seen that price-earnings multiples in the market are influenced by expected growth, dividend payouts, risk, and the rate of interest. Higher anticipations of earnings growth and higher dividend payouts tend to increase price-earnings multiples. Higher risk and higher interest rates tend to pull them down. There is a logic to the stock market, just as the firm foundationists assert.

Beauty is everywhere a welcome guest (Johann Wolfgang von Goethe)

Thus, when all is said and done, it appears that there is a yardstick for value, but one that is a most flexible and undependable instrument. To change the metaphor, stock prices are in a sense anchored to certain “fundamentals” but the anchor is easily pulled up and then dropped in another place. For the standards of value, we have found, are not the fixed and immutable standards that characterize the laws of physics, but rather the more flexible and fickle relationships that are consistent with a marketplace heavily influenced by mass psychology.

Not only does the market change the values it puts on the various fundamental determinants of stock prices, but the most important of these fundamentals are themselves liable to change depending on the state of market psychology. Stocks are bought on expectations – not on facts.

The most important fundamental influence on stock prices is the level and duration of the future growth of corporate earnings and dividends. But, as I pointed out earlier, future earnings growth is not easily estimated, even by market professionals. In times of great optimism it is very easy for investors to convince themselves that their favorite corporations can enjoy substantial and persistent growth over an extended period of time. By raising his estimates of growth, even the most sober firm-foundation theorist can convince himself to pay any price whatever for a share.

During periods of extreme pessimism, many security analysts will not project any growth that is not “visible” to them over the very short run and hence will estimate only the most modest of growth rates for the corporations they follow. But if expected growth rates themselves and the price the market is willing to pay for this growth can both change rapidly on the basis of market psychology, then it is clear that the concept of a firm intrinsic value for shares must be an elusive will-o’-the-wisp. As an old Wall Street proverb runs: No price is too high for a bull or too low for a bear.

Dreams of castles in the air, of getting rich quick, may therefore play an important role in determining actual stock prices. And even investors who believe in the firm-foundation theory might buy a security on the anticipation that eventually the average opinion would expect a larger growth rate for the stock in the future. After all, investors who want to reap extraordinary profits may find that the most profitable course of action is to beat the gun and anticipate future changes in the intrinsic value of shares.

Still, this analysis suggests that the stock market will not be a perpetual tulip-bulb craze. The existence of some generally accepted principles of valuation does serve as a kind of balance wheel. For the castle-in-the-air investor might well consider that if prices get too far out of line with normal valuation standards, the average opinion may soon expect that others will anticipate a reaction. To be sure, these standards of value are extremely loose ones and difficult to estimate. But sooner or later in a skyrocketing market, some investors may begin to compare the growth rates that are implicit in current prices with more reasonable and dispassionate estimates or the growth likely to be achieved.

It seems eminently sensible to me that both views of security pricing tell us something about actual market behavior. But the important investment question is how you can use the theories to develop practically useful investment strategies