Throughout history super soaraway shares have defied gravity – for a while
Ben Laurance
With the benefit of hindsight, the grass skirt should have been a giveaway. It was the mid-1980s and the investors’ love affair with biotechnology companies was at its most passionate. Robert Swanson, a venture capitalist by training, was chief executive officer of Genentech – one of the few biotech groups that had managed to bring some products to market.
Swanson was riding the wave of biotech fever with great enthusiasm. His company had developed a product, t-PA, which was hailed (largely by Genentech itself) as the greatest advance in the treatment of life- threatening blood clots. The company’s share price had rocketed. Employees were encouraged to don T-shirts bearing the words “Clot Buster”. At Friday office parties Swanson would don a grass skirt to dance the hula.
Investors were not concerned. They would let nothing qualify their affection for Genentech. At least, that is what they believed in 1987. Then, some more cautious souls began to subject Genentech to some of the more conventional tests of investment analysis. Was its share price really justified by even the most optimistic of earnings forecasts? Should investors not worry that there was no hope – even in the medium term – of the company giving its shareholders even modest income from dividends? Genentech’s share price, which had touched $65, fell to $18 within 12 months.
The Genentech episode was just one example of a share price gaining a momentum that defied the conventional rules of stock market pricing. More than a decade later, analysts are struggling to find a new set of rules by which the soaring share prices of a new group of companies – “dot.com” stocks – can be explained, and when the “conventional” tools of valuation seem to have been abandoned.
But even the “conventional” measures are relatively young. At the start of the 20th century, there were some rough-and-ready rules for estimating how much a company should be worth. The world had moved on from the days of the South Sea Company, whose success in the early 18th century had spawned scores of imitators whose only aim was to part gullible investors from their money.
Money was raised to extract silver from lead, build a wheel of perpetual motion and trade in human hair, among many other things. Most strikingly of all, one unidentified soul launched “a company for carrying on an undertaking of great advantage, but nobody is to know what it is”. Dozens of people subscribed funds for this project. The promoter closed his doors after five hours, took the money and vanished.
But it was only after World War I that a generally accepted system for valuing shares was devised. It was outlined by American John Williams in The Theory of Investment Value. The basis of his ideas was simple: that every investment has an “intrinsic value”, and that value is determined by the dividend income it yields now and the likely rate of increase in the future. Add up all that future income, apply a “discount rate” according to the difference one attributes to money this year as opposed to money in the future, and bingo: you can work out the current intrinsic value.
In theory, the idea seems fine. If a share’s price is less than its intrinsic value, it should be bought; if its price is higher than its intrinsic value, it should be sold.
But there are two clear snags: first, over what period does the investor assume a particular growth rate for the income an investment will yield? Second, what if the discount rate were to change? This would throw out comparisons between a share currently giving a high yield but with low growth prospects and a second stock with low yield but better growth prospects.
Nevertheless, the notion of intrinsic value provided the underpinning of valuations for a generation of investors. Dividend yields were the crucial measure of a share’s value. Arguably, the more modern approach – of comparing a share’s price with the net earnings attributable to that share – is merely a variation on the well- established theme. After all, no company can pay dividends for very long unless it has the earnings from which to pay them.
The main intellectual challenge to the idea came from the eminent economist John Maynard Keynes, whose 1936 General Theory pointed out that no one really knows what is going to influence future earnings and dividends. So investors spend their time trying to anticipate how the view held by the rest of the market will change. Every other investor is trying to do the same. So the market is trying to guess what the market guesses the market will guess.
Keynes wrote: “It is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30 if you also believe that the market will value it at 20 in three months’ time.”
Keynes used the famous example of a beauty contest in a newspaper. The reader’s aim is to select the six prettiest faces from 100. The winner is the person whose choice conforms most closely to the average of all those who enter the contest. The sensible strategy is not to choose the six which you individually find most pleasing, but to choose those which you believe the readership will select. But every other canny reader will be doing the same. So, you have to guess what other readers guess other readers will guess.
If you apply this to investments, prices of shares can sustain a level well above what their intrinsic value would suggest. They stay there not because the shares’ holders believe that this is the “right” price, but because they believe other investors will soon believe that the market will believe them to be worth more.
Nevertheless, since the Sixties, the main plank of share valuation has been that of price:earnings ratios – a share priced at 120 in a company which will give earnings per share this year of 10 has a p:e ratio of 12, for example. And since the mid- Nineties, a variation of this has appeared under the acronym of Ev/Ebitda, standing for enterprise value divided by earnings before interest, tax, depreciation and amortisation. Enterprise value equates to a company’s stock market value plus its debts: in other words, the enterprise value of a company with a market capitalisation of R60-million and debts of R40-million has an enterprise value of R100-million.
A further measure which has its supporters is economic value added: this is a fiendishly complicated variation on an old favourite of discounted cash flow – taking the flow of cash a company is likely to produce over coming years and attributing a current value to that flow.
But – particularly in the current environment, where huge values are being put on companies which are making losses and will do so for years to come – measures such as yields and book value are looking quaint but unloved.
The essential point is this: conventional valuation measures have been abandoned at regular intervals over most of the 20th century. In the 18 months between March 1928 and September 1929, share prices on Wall Street increased by more than they had in the previous five years. Exactly as Keynes was later to explain, people bought shares because – whether or not they thought the prices were already too high – they believed that they would go higher. In those 18 months, the price of shares in Radio Corporation of America increased fivefold. (After the Great Crash, they fell by 97% from their September 1929 peak.)
Between 1959 and 1962, there was a fashion for what were then considered high- tech stocks, the “tronics boom”. To be highly rated, a company had to have a name which suggested that it was a “tron” – Vulcatron, Transitron, Circuitronics and Videotronics, for example.
The American Music Guild, whose business consisted of selling records and record players door-to-door, caught the Zeitgeist. It changed its name to Space-Tone, and its share price rose sevenfold within a few weeks.
As with all crazes, it died out – and investors suffered.
In the mid-Sixties, there was a boom in “concept stocks” where a company was highly rated because it had a smart idea even if it was unclear how this would ever be translated into income. (This may sound eerily familiar to observers looking at dot.com stocks today.) P:e ratios commonly topped 100.
In the early Seventies, the vogue was to invest only in large, blue-chip stocks. In the US, this clutch of favoured behemoths was known as the “Nifty Fifty”. The fad drove Polaroid’s shares to a p:e of 90 and McDonald’s to 83. (By 1980 their p:e ratios were 16 and 9 respectively.) Just as the notion of a two-tier market has been so discussed in the past 18 months, Forbes magazine remarked at the time that “[the Nifty Fifty appeared to rise up] from the ocean; it was as though all of the US but Nebraska had sunk into the sea. The two-tier market really consisted of one tier and a lot of rubble down below.”
In 1983, there was a rerun of the early- Sixties boom. New issues were the fad. In that year alone, new issues raised more money in the US than in all of the Seventies. The message was simple: if a company was coming to market, buy the shares; they were bound to go up. And go up they did – until they collapsed, by an average of 50%, in spring 1984.
Also in the Eighties, biotechnology became fashionable – for a while. Genentech led the way in 1980: its share price almost tripled on its first day. There were plenty of followers. Some were selling not on price:earnings ratios of 50 (which would have been optimistic enough) but at prices which represented 50 times these companies’ annual sales . In the second half of the Eighties, biotech stocks lost, on average, about three-quarters of their value.
There were other disasters. Heart transplant pioneer Christiaan Barnard put his name to an anti-ageing cream from a company called Alfin Fragrances; the cream failed to gain approval, and Alfin’s share price fell by 95% in three years. Other companies whose shares were fleetingly hailed as the new IBM (not many people knew of Microsoft then) were exposed as simply fraudulent.
Each speculative boom has forced analysts to devise a new way of valuing stocks and providing ridiculous prices with a veneer of credibility. Each boom must have had John Williams and Benjamin Graham spinning in their graves. Keynes would merely have laughed.