Rational Value: Your Key to Investment Sanity

One of the phrases that survived the tenure of former Fed Chairman, Alan Greenspan, was his characterization of the stock market bubble of the late 1990s as "irrational exuberance." In two words, he drew a very accurate picture of the mood of "the herd."

I refer, of course, to the great, now-dwindling body of individual "investors" who, as a dog chasing its tail, follows the crowd's own path and tries to predict what it's going to do from one day to the next. At the time that phrase was coined, of course, the herd was under the influence of what the Street refers to as the "greater fool theory" by which otherwise sensible people will say to themselves, "I may be a fool to buy this stock at this price; but some greater fool will buy it from me at an even higher price." The disconnect between reality and fantasy was then in full play as it was during the housing bubble that followed.

Presidential candidate, John McCain, in a recent interview with ABC's Charlie Gibson, appropriately borrowed from Greenspan's label, calling the current situation "irrational despair." And that label is equally apropos on the downside. Where blind greed drives the bubble, blind fear drives the bust. And this is what's at play at this moment.

For those people who have bought into the securities industry's view that investing is playing the stock market, such fear is understandable. The challenge is in guessing what the direction of the market will be in the next hour, day, or week, and betting on that guess. And they have all kinds of fancy software that displays graphs of the prices and volume of sales over varying periods of time in gorgeous color and actually presumes to tell people when they should buy or sell! Right now, all arrows point to the basement. And the freefall is caused by all but a tiny fraction of those who hold shares being convinced that they had better get out while their holdings still have any value at all. This is insanity!

Doesn't common sense tell you that you can't forecast what your fellow gamblers will do tomorrow when you don't even know what you're going to do next? And doesn't it also make sense that, with more than one-hundred different schemes out there for trying to predict the future price of stocks by looking at historical price and volume movements, that none of them work? After all, if any of them did, why would you need more than one?

People are fearful now because most believe that a share of stock is nothing more than a token lying on the green, felt surface of a table in this crazy stock market casino. In their view, a share of stock has no intrinsic value and can therefore be worth nothing if the market values it as such.

Well you can thank the securities industry for much of today's problems! If brokers were to be compensated by receiving a miniscule fraction of the value of your holdings every year—instead of being paid every time you either buy or sell a share of your stock—they wouldn't be nearly so eager for you to sell your winners or buy losers! It's the practice of transaction-based compensation that has made it more profitable for them to induce you to gamble and churn your account instead of truly investing.

Suppose I were to tell you that investing is not guesswork but is really closer to being a sure thing. Consider for a moment what a graph of the stock market looks like—especially in these volatile times. Driven up and down by the totally unpredictable whims of those who are betting on the movement of the market—or some individual stocks that they thought had a promising story, that graph looks like a roller coaster. The closer you stand to observe it—the shorter the term over which you examine it—the more unpredictable it appears. Looking at the hourly movement of prices, it's very volatile. Daily or weekly movement isn't much better. It's only when you stand back from the graph far enough for those little zigs and zags to blend into each other and appear to be just one big, fat line that you can see, for all of the movement, that the trend of that fat line is, and has been, up. Consistently.

Today, while the market is plummeting, what is happening to the companies whose shares comprise that market? Aren't they still running, producing the goods and services they produce, selling those goods and services, and growing their earnings? Oh sure, in an economy that is being shaken like today's—mostly because people have used an excess of credit to acquire things they couldn't afford and shouldn't have bought—that individual corporate growth will slow down as people start tightening their belts and spending less. But the well-managed companies whose products are still required or desired will just keep on truckin'. And, against the background of the falling share prices, the graph depicting their revenues and earnings will continue to track upwards—albeit with a slope that may shallow some.

What does that have to do with anything, you might ask. Well, if you're someone who bought a bunch of stock in one of those companies because you were betting that the price of that stock was going to go up after you bought it, you'd be afraid that you were going to lose money on that "investment." And, when the market acted like it's acting now, you would probably not wait all that long to get rid of it (and capture your loss forever, by the way).

On the other hand, if you had actually invested in that company, you would have known that the stock represents the small fraction of that company you own. And you would have been interested only in the ability of the management of that company to continue to operate successfully and produce and sell what it produces.

So long as it continues to do that, substantially as you expected it to when you bought it, given the state of the economy and the buying power of its customers you would be a happy camper. And, you'd probably be watching with somewhat detached interest as the herd, in its blundering ignorance, captures its losses at an increasing rate. Better yet, if you should have enough cash to do it, you'd take advantage of the "fire sale" that's going on around you and scoop up the bargains!

Some time ago, I devised a tool called "rational value" that can help an investor get through times like these with some degree of serenity. Let me describe it to you—hopefully with enough simple logic to give you some confidence in the concept.

The market price of a share of stock—or anything else, for that matter—is the price at which there is a willing buyer and a willing seller. However, because in the short term the irrationality of buyers and sellers can be rampant, the price at any given moment is hardly reliable as a benchmark of actual value.

Over a period of time, however, taken on the average, the market price can be a much more valid benchmark of value. Given that the market goes up and down, the midpoint of the swings in that price should be a fairly good indication of the long-term value of the stock. However, there's one more issue that flies in the face of using the average price. Over time, the price of a well-run company goes up! That's why, when you look at the trend of the market from far enough back, the trend of the market as a whole has been up. So, it doesn't make much sense to use a historical average price when the average or median of the prices over the past five or ten years would have been below the current price.

Just why does the price go up? It's because the value of the company increases over time if the company has been run properly. Every year, a high quality company will bring in more revenue than it did the year before. And, assuming management has been as efficient as it should have been, the company will have more left after paying its expenses than it did the year before.

The profit that remains after expenses and taxes have been paid are referred to as "Earnings" and they are added to the value of the company in its books every year. Obviously, the more the company is worth, the more intelligent investors are willing to pay for it. Hence, the value of the shares should rise every year.

Does this have any connection with the stock market? Absolutely not! The price of the stock can go up or down at the whim of the herd; and, on a daily basis, it has nothing to do with the actual value of ownership of the company.

So, since it's the retained earnings that actually determine the real value of the shares of a company over the long term—at least in the minds of genuine investors—then, by connecting the price of the stock with the value of the company's earnings, we find a much more finite assessment of the value of that share of stock. That relationship between the company's earnings and its stock price is referred to as the Price:Earnings Ratio or "PE." And, its calculated by dividing the current price of the stock by the earnings accumulated during the previous twelve months. So important is this bit of data, valuable space is devoted to displaying it along with the closing price in the crowded financial pages of most newspapers.

If I were to tell you that I paid $50 for a tank of gasoline, without knowing how many gallons that tank holds you wouldn't be able to tell whether it was cheap or expensive. However, if I tell you I paid $4.00 for a gallon, you now have a unit value to compare it with historically and currently. And, you have a pretty good idea of what is cheap or expensive in view of history. Ditto a pound of coffee or any other commodity.

The same is true of the PE ratio, which is nothing more than the price paid for one dollar's worth of a company's earnings. Armed with that figure, you can tell whether the price is high or low for that stock. However, since you aren't nearly so familiar with the track record for that PE ratio over the past five or ten years as you are with the average price of a gallon of gas, you'll want to dig up that information from one of the many Websites that offer what you need.

To calculate the Rational Value of your portfolio, you will need to calculate or obtain the Relative Value (RV) or the Historical Value Ratio (HVR) of each of your holdings. [The RV is the current PE divided by the 5-year average PE. The HVR is the current PE divided by the median PE over the past 10 years. ]

The significance of those values is that they tell you how the current cost of a dollar's worth of that company's earnings compares with the average or midpoint of those PEs over time. It stands to reason that the midpoint in PE ratios over an extended period implies that, during that time, the price went both higher and lower. It could therefore be construed that the midpoint would be an approximation of how much people would pay for the stock when they were rational—neither exuberant nor despairing. Thus, if the HVR for Microsoft were to be 37.8% (which it was when I wrote this), you would know that the stock is currently selling for a price (expressed as a multiple of earnings) that is less than 40 percent of what investors have considered to be a fair price over an extended period. Were the HVR to be 100%, it would be selling at the price that was considered reasonable or rational.

To find out what your portfolio is really worth, and not what the herd thinks it's worth in the depths of their insanity, you have only to divide the current market value of each of your holdings by the RV or HVR.

Here's an example: Say you had 200 shares of Microsoft. [What you paid for those shares is totally irrelevant, by the way. They're worth only what you can get for them today or in the future.] And, at $22.30 per share, the current market price, your holdings are worth a paltry $4,460.00.

You should be pleased to know, however, that the rational value of those holdings is a very comfortable (4,460 ÷ 0.378) $11,799! And, because the time will eventually come when the herd does recognize the true value of those shares—after the ignorant players are driven out and sell to the more rational investors—you should be able to count on those shares reaching that value and then some. You have only to be patient.

If you calculate the rational value of your entire portfolio right now, you'll doubtless be very pleased and surprised to find out just how much your holdings are really worth, when treated as the valuable credentials of corporate ownership they really are.

You can obtain the HVR directly if you sign up for a free, 45-day membership in StockCentral (which you can access at www.stockcentral.com ). Once you have done so and can access the full version of Take Stock at that address, you can enter the ticker symbol for each of the companies in which you own shares and click on the "TSSW Form Back" hyperlink on the right-hand frame. On the form that's displayed, look for the "HVR" on the right side of the page. [Disclaimer: I receive no compensation or have any other direct financial interest in that site. However, I serve on the board of directors of the parent company, ICLUBcentral, Inc., and am therefore familiar with and can vouch for their services. This reference is offered only as a simplified means of obtaining the information you can use for the purpose described above.]

Truth be told, the sooner the American public recognizes the true meaning of investing and sees trading and short-term investing as promoted by the securities industry to be the dangerous game it is, the better. When that happens, everyone will be ready, willing, and able to learn the simple rudiments of picking high quality companies to invest in. They'll begin to confidently reap the consistent rewards this method of investing can produce for them. And we'll be back in a healthy investment environment. If only someone with the reputation and national stature of a Warren Buffett or a Peter Lynch would come along and publicly and loudly champion the cause of the true investor, we'd soon see a return to rationality and sanity in the the stock market!

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Investing: Fear and Ignorance

EllisT

Wed Oct 8

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