Peter Lynch of The Magellan Fund fame once offered that stock market prices cannot conform to the hypotheses of Efficient Markets and Random Walk at the same time. The former mandates that asset prices reflect all information at all times. The latter contends that asset pricing is sensitive to so many variables that predicting cause and effect is all but impossible.
In the laboratory of the Pandemic, it is tempting to suggest that global stock market movements have complied with Random Walk more than Efficient Markets. However, there is also merit in considering the background against which asset pricing decisions are now made. Perforce, the Pandemic and our reactions to it, have altered the economic as much as the social framework. The question posed by these changes is both simple and incredibly complicated. Do we “live with COVID” and accept the changes wrought or do we return to the environment of 2019 entirely?
Both outcomes present investment opportunities. If we have changed, then these changes will need to be accommodated and entrepreneurs will emerge to provide that accommodation. If we return to normal, companies currently trading below the pre-COVID trend should return similarly.
The question of “new” or “old” normal also presents issues for valuation. For our purposes, value methodologies fall into two camps: comparative and standalone. Back of the envelope PERs and EV ratios tend to the former. Complicated DCF and EVA analyses are the latter. This schism has tended to be determined by the perceived “quality” of the analysis. They have not been divided by the changing complexion of company accounts. Indeed, we would argue that valuation methodologies are increasingly post-event rationalisations, providing a mathematical “proof” for a share price movement rather than driving valuations themselves.
Consider two companies. One US, one UK, both capitalised towards the top of their respective indices and both have played high profile roles in the COVID period. Company A’s share price has increased by 50% in the last 12 months. Company B’s has risen by less than 2.0%. Company A is US listed. It trades on an EV to revenue ratio of almost 9,000. Company B is UK listed. It trades on an EV to revenue ratio of less than 5.0. Pulling the valuation all the way down to the end of the income statement, Company A’s 2020 PER is 42.7x while Company B’s is 36.0x.
In pure terms, this comparison reflects that Company A’s ability to translate revenue into earnings is more advanced than Company B’s. Company A’s gross margin is 38.2%while Company B’s is 79.5%. This gap all but evaporates at the operating level with A reporting 24.1% and B reporting 21.8%. Thus, over 2020, while Company A’s share price performance made news, it could be argued that it was merely catching up to the valuation metric (PER) of Company B as the equity markets “woke-up” to the differences in economic structures.
This distinction is important, particularly for companies seeking to list equity on a stock market. It is important, also, to understand that valuation methodologies are applied to translate economic models into a stock market lexicon. They are not supposed to drive the development of the model themselves. In effect, companies seeking listings are “fitted” for a valuation in the way that any father of the bride has a suit tailored. It is for an event (IPO or wedding) and its function thereafter is limited. And yet, these suits can determine who invests in the company and under which strategies they invest.
VIVA Investment Partners is building its knowledge of the “tailoring” required to get the most from the public markets. We work with entrepreneurs. Not to adapt their models to fit the markets but to prepare them for the work required to “fit in” to their best advantage for the long term. We will be writing and presenting more on this work in the months to come.
Where do we go next? That all depends on matters far outside the capital markets. Interest rates are close to zero, but inflation is rising. Personal and corporate debt is reducing as Sovereign debt rises, apparently exponentially. The world, to all intents and purposes, remains closed but yearns to reopen. In this environment, the capital markets are likely to continue offering post-event rationalisations rather than valuation guides.
Company A and Company B? Apple Inc., and AstraZeneca plc.