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Of great interest to us are the internal workings of markets. These are often very good indicators of where we are in the ebb and flow of valuation cycles. Valuations work, provided you are patient. They especially work if the constructed relationship is mean reverting and also non-mainstream.
Recently, we have been looking at equity valuation dispersions: that is, the gap between highly valued equities at one end and lowly valued equities at the other. It is unproductive to guess at where the natural relationship lies: it can be plotted and therefore a mean or average level can be observed, but does the average mean anything in this instance?
Of greater interest is when the range relationship becomes distorted due to the radical re-pricing of one group, or a thematically linked group of stocks.
A glance at the above chart indicates that, in recent financial times, this happened most dramatically in the TMT bubble which burst in 2000. In 2000 the ratio of the book multiple of the high price to book value stocks ran up to a multiple of 2x that of low price to book value stocks. Bear in mind, this is a measurement of all listed equities, not the most highly rated, nor is it sector specific. In the TMT boom, a group of telecom and tech companies became so spectacularly overvalued that they pushed the averages.
The most recent plot of this relationship is suggestive that another wave of enthusiasm is engulfing markets and in some of the same places: tech and biotech, two sectors that are very well represented in the NASDAQ index. The cumulative annual rate of outperformance of the NASDAQ compared with global equities has reached.
A simple chart of the world internet index against a world equities index reveals the magnum of outperformance very clearly.
Turning back to our valuation dispersion chart: we note that an upswing is clearly underway. We also note that at a multiple of 1.3x, the relative valuation contortion is nothing compared to the 2000 period. Limited comfort can be drawn from this; the 2000 period measures as a 3.5x standard deviation event. It was the mother of all bubbles, unsurpassed by anything of the past 100 years and comparable only to the Japanese equity market bubble of the late ‘80s and the US residential bubbles of the ‘00s.
Financial commentators have become very sensitive in this area and the tendency to cry bubble has multiplied in recent years. Whereas we would certainly question the valuations on offer in some of the hotter concept areas, it is hard to entirely back the bubble claim.
The growth oriented equity investor is left in an uncomfortable place. In a world where the paths to commercialising intellectual property have become admirably short, we wish to invest in new technologies where human inventiveness is at its best. On the other hand, investors of every stamp know that one of the greatest determinants of value obtained is the price paid.
A cooling would be helpful now, it has just started.
Industry profitability, as measured by a firm’s return on capital employed (ROCE), is determined by how successfully a firm can capture the value it creates for its buyers, which can differ depending on the structure of the industry. When the structure is favourable, companies are typically able to retain a decent proportion of the value (e.g. medical supplies). Conversely, in an unfavourable environment, much of this value would be competed away to others (e.g. autos), be it customers (driving down prices), suppliers (inflating costs), substitute products (reducing differentiation) or potential or existing rivals (eroding market share).
It is also important to distinguish between cyclical factors that affect short-term profitability, such as the weather or a particular business cycle, from the structural fundamentals that shape long-term profitability. This is manifested through the collective strength of the five key competitive forces (defined by the consultant, Michael E. Porter) that governs price, cost, and investment input required:
Often one or more of the five forces will take prominence in an industry. For example, in an industry with an oligopolistic market structure, natural barriers exist inhibiting new entrants via cost economies of scale. Further, these companies command superior pricing power as consumers have limited alternatives; therefore the main threat lies with its existing adversaries. expired domain list On the other end of the scale, in an industry comprising of many competitors where entry barriera are low, substitutes can easily transpire and so the bargaining power of customers becomes a greater risk. In this case the firm suffers intense pressure from a multitude of the ‘forces’, weighing down profitability.
A firm must be able to identify the dominant force(s) within its industry and position defensively against them to stay relevant in the long-run. Thereby, industry structure will become a critical influence on the competitive strategy undertaken. It is also essential to realise that industry trends can change over time. A firm is not tied down by its industry, on the contrary, it can actively improve the industry’s intrinsic attractiveness by finding innovative ways to compete and alter the overall industry dynamics for the better as long as the strategy they employ is a constructive one.
The application of classic Porterian criteria is central to our selection of “global franchise companies”. Although the underlying thinking can be critiqued as having become generic, even homespun, it is remarkable how strong these factors are in explaining long term equity returns at the individual company level. The key words here are “long-term” as most investors, including institutional investors, simply do not invest with long enough time horizons for Porterian forces to exact their toll. The impatient human mind is drawn into shorter term trends and is prone to overreact to temporal data changes. A watchword for this over-caffeinated approach is “thematic investing”. Beware the thematic investor.
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