Relationships are the most important thing in life! Value investors care about (the price-value) relationship too!

Last year, many of us have experienced that living our lives without other people is pretty dull. And hopefully 2021 will bring back all the strongly missed personal interactions! Many of us want nothing more than to do all the usual things taken for granted: visit restaurants, having a drink or two, going to a party and on vacation, or just spending time with people you like. Relationships are key!

In the realm of value investing the relationship between price and value is of special importance. You can think of securities prices of being determined of the next marginal seller and buyer or supply and demand. In economic terms the clearing price. In general, security prices are influenced by

  • fundamentals
  • emotions / psychology
  • technicals

Of course, each factor can be affected by all the other factors.

Fundamentals are the things determining intrinsic value like the current balance sheet, earnings and cashflows and risks involved, which, toghether with ‘riskfree’ interest rates form applicable discount rates. (let’s simply assume that earnings equal distributable cashflows here)

Emotions determine how individuals and the group of market participants as a whole interprete and react to fundamentals and in a more general sense. Are they more worried about losing money or missing opportunity? How much are they willing to pay for a dollar of (risky) earnings?

Technicals describe all the reasons that are neither fundamental nor emotional but transactions arise from strict rules or regimens. Some fund managers must manage positions to stay within strict limits for their portfolios or simply sell-off spin-offs due to their mandate. Sometimes, politics are the driver (see China Mobile). It’s about supply and demand – (maybe?) the single most important economic principle. And, the next marginal buyer and seller are those driving prices.

  • As I only finish this piece as of January 27th: For technicals just look at
    • Gamestop (GME)
    • Bed Bath & Beyond (BBBY)
    • Some other stocks in the media with high short interest

A view on returns

We could observe a stock’s performance within the following framework:

  • In t0 we pay a price (P0) for the stock or a certain multiple (P0/E0) for each dollars of earnings. That’s the P/E-multiple at the time we buy the stock in t0.
    • In between we might receive dividends.
  • In t1 we sell the stock for another price (P1) and at a certain multiple P1/E1.

Both multiples are influenced by all three of the above factors. From a fundamental perspective, each multiple can be translated into implied assumptions for growth and discount rates (in a DCF Valuation) and vice versa. Additionally, the earnings (E) part of the multiple is a fundamental itself. Psychology or emotions drive the multiple-ratio (P/E) and technicals drive the price (P), and thus the ratio.

When looking at a potential investment we might ask where our (potential) edge might come from.

  • Do we have a better view on (long-term) fundamentals?
  • Is the rest of the market panicking, selling of a very solid business toghether with other securities during a market crash – than our edge might come from having a firm view and keeping our emotions in check.
  • Or is their a special situation that forces other (big) market participants to sell-off a certain stock for sole technical reasons? As Howard Marks says

»The beauty of forced sellers is that they have no choice. They have a gun at their heads and have to sell regardless of price. Those last three words – regardless of price – are the most beautiful in the world if you’re on the other side of the transaction.« – Howard Marks

Howard Marks, The most important thing illuminated

Of course, the above is idealized and only applies when there are many forced sellers and fewer willing buyers.

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