Conventional wisdom and historical evidence support the observation that “stock prices always go up over time”. On a long enough timeline, stock returns of substantially all developed countries have been positive, driven by inflation and real GDP growth if nothing else. Businesses are created and fail, and individual stocks enter and exit market indices all the time, but the aggregate “market” of thousands of stocks is expected to grow into perpetuity. Unfortunately for stock-picking investors, the conventional methods used to value individual stocks also embed this expectation, often to the detriment of investment returns.
Morgan Stanley recently published a report on the UK retail sector exploring this idea of structural overvaluation. Of the 19 stocks in the FTSE 350 General Retail Index in January 2007, only four remain in the index today. Five stocks disappeared due to corporate actions, which means ten of the UK’s largest listed retailers either went into administration or shrank out of the FTSE 350 over the course of 12 years. Granted, the retail industry globally has seen significant upheaval in recent years due to e-commerce, but even so the attrition rate (over 50%) stands in stark contrast to the idea that “stocks” generally go up over time.
If we rewind back to 2007, it is almost certain that these retailers were being valued by the market on either a multiples (e.g. P/E) or DCF basis, or both. The problem with both methods is that they assume the stock being valued trades profitably into perpetuity, which is a fair assumption for the entire market but not for any individual stock. If we take multiples to be a shorthand proxy for DCF, we are effectively capitalising a flat stream of earnings into perpetuity at a discount rate that is the inverse of the multiple applied (mathematically, it could also represent a higher discount rate minus some perpetual rate of earnings growth). The problem is, if the business doesn’t survive into perpetuity, a market multiple or average of comparable peer multiples will almost invariably overvalue the stock.
The DCF methodology, which allows for greater flexibility in forecasting cash flows, typically incorporates a terminal value at the end of the forecast horizon – which also effectively assumes the business being valued grows its cash flows into perpetuity. Assuming a positive terminal growth rate – as is typically taught in Valuation 101 – further exacerbates the inherent overvaluation because it implies that not only is the business a going concern into perpetuity, it can also earn above its cost of capital forever. This can be especially misleading when, as is often the case, the terminal value accounts for half or more of the enterprise valuation.
Fast forward 12 years and we can see with the benefit of hindsight that this embedded assumption of any individual stock trading profitably into perpetuity is clearly overoptimistic. Looking across the pond, the U.S. stock market is also populated with has-been retailers (and stocks in other sectors) that scream “cheap” by any traditional valuation methodology, but only because the market is discounting an elevated probability that the business goes bankrupt in the foreseeable future.
It should also be clear by now that this upward bias doesn’t just influence the buying of stocks; it can also adversely influence short selling by making a business appear more valuable than it actually is. This can result in covering a short too soon or passing on a lucrative opportunity altogether. At Montaka, we are particularly cognisant of this bias as our short framework favours stocks that are in structural decline and thus less likely to survive into perpetuity. In these instances, it pays to be less prescriptive around the strict valuation framework and give greater weight to the qualitative analysis of structural headwinds, asymmetries and misperceptions.
Ultimately, investors need to think carefully about which businesses deserve to be valued on a “forever” basis and which ones are likely to decline well before then. Growth businesses in industries with structural tailwinds may have a longer life cycle than mature businesses in declining industries. It is by no means easy to predict whether a business will be around forever, but that doesn’t mean investors shouldn’t consider the propriety of terminal values or multiples on a case-by-case basis.