The Mysterious and Infuriating World of Stock Valuations
By Danielle Woods, Financial Advisor and Attorney
I was reading the 4th quarter 2023 report published by Artisan International Value Fund (APDKX/ARTKX). This report is provided to all shareholders and offers an overview of recent market data as well as some thoughts on where it’s all going. Reports like this are often published quarterly and annually for anyone to read.
Reports like these are a wealth of information. They are written by some pretty savvy professionals who make a lot of important decisions with other people’s money. And they are short! I read quite a few of these and often skim them for phrases that jump out as noteworthy. I encourage you to pick one at random per quarter and just see if anything jumps out at you.
In the case of this report, the following paragraph inspired this blogpost:
The investing environment in 2023 was much better than the operating environment. In the United States, for example, the S&P 500 Index increased by 26.3% while 2023 earnings for the companies in the index are forecast to grow by less than 1%. Valuations are up.
What is a Valuation?
The Motley Fool actually does a very good job of explaining this in their online post aptly titled, “The Definitive Guide: How to Value a Stock.” However, the article deep dives into some math metrics that won’t appeal to everyone. I do like the following quote from the post:
A stock’s intrinsic value, rooted in its business fundamentals, is not always the same as its current market price…there is not just one way to value a stock.
Said another way, the term “valuation” refers to the appropriate price of the stock, which is not necessarily the same price you see on the ticker screen.
Valuations are determined by many factors, including the price of the stock versus the earnings per share of the company (P/E ratio), year-over-year growth rates, trend in dividend payouts, market share, the value of outstanding shares divided by annual revenue (P/S ratio). Those are quantitative factors, or characteristics that can be quantified.What about Quality?
I studied sociology in college as part of one of my minors. We considered quantitative versus qualitative measures constantly. As an investor, so should you. Why? Because a “stock” is a portion of ownership in a real company. A company is made up of its leadership, its employees, and its customers. It is not a nameless, faceless entity pared down to a stock ticker of 3-4 letters and a daily price.
At Propel, we do not focus entirely on the quantitative data of a company, but also the qualitative data. Who are the people in senior management? How do they treat their employees? What is turnover like in terms of employees and customer base? What is the cause of turnover? Does the company participate in its own community? Are the company policies flexible and resilient in the face of economic changes? Can the company own up to its mistakes and learn from them?
This is important because how an investor feels about the answers to those questions will impact the company’s value to that investor just as much, if not more, than the quantitative data.
“Valuations are up.”
Back to the report that prompted this blogpost, what does it mean? When I read that line, I immediately thought, “the market is expensive.” But then I remembered that “the market” is actually representative of a small number of largest companies. These companies were nicknamed The Magnificent Seven in 2023 and produced the vast majority of the returns reported. The companies in question are Meta Platforms, Nvidia, Amazon, Apple, Alphabet (Google), Microsoft and Tesla.
The buzzword in 2023 was “AI.” Is it real? Absolutely. Is it brand new? Not at all. So why did it grab the attention of investors in 2023? We can’t know for sure, but my teammate Amanda Vaught’s theory is that it started with the launch of ChatGPT. Regardless, it’s almost guaranteed that a small group of investors made a whole lot of money. The much larger group of passive investors who simply invested in the stocks that were popular considered themselves geniuses.
The Artisan report referred to the S&P 500 with much higher performance in 2023 than could be supported by its earnings. Those above-listed seven companies make up more than 25% of the S&P 500 Index and produced huge returns while the other 493 companies did very little in 2023. Therefore, valuations are not high for all companies.
S&P 500 is a misnomer
The Standard and Poor’s 500 Index is known as the S&P 500. It consists of the largest 500 companies in the United States. Within the Index those companies are market-weighted, meaning the size of the company determines the size of its position in that index. They do not each represent an equal 1/500th piece of the pie.
Below are some charts that our JP Morgan contact, James Moran, shared with us in a recent Zoom call. It illustrates some interesting data points of the 10 largest companies vs the rest of the companies in the S&P 500.
Our advisors at Propel do not believe in concentrating investment portfolios in the largest companies in the United States just because they are experiencing a surge. Periods in our history including the Dot.com bubble of 1999, the “lost decade” of 2000-2010, the subprime mortgage crisis of 2018-2019, and the COVID collapse of 2020, all illustrate that nothing can be taken for granted.
Our clients’ portfolios absolutely include those large and successful companies and benefit from those rising values when they are performing well. Portfolios will also feel the effects of a market downturn like we saw in 2022. Rather than attempt to time the market, we promote a more diversified portfolio that includes undervalued companies that we and other mutual fund or ETF managers believe offer long-term results based on due diligence.
Some performance giants pay off over long periods, but many can simply offer increased volatility in market value. Depending on the time period reviewed, it’s not always possible to determine the payoff.