In his latest Greenlight Capital Q4 2020 Shareholder Letter, David Einhorn discusses why stocks become overvalued, citing three types of ‘valuation indifferent investors’ who don’t consider valuation as part of their investment process. Here’s an excerpt from the letter:
This begs the question as to why a stock might trade at 20 times a silly price. Of course, there is the possibility that we are just wrong and bad at measuring silliness. But setting that aside, we think that the answer is that certain stocks are held exclusively by valuation indifferent investors.
In our early training, one of the first concepts we learned is market capitalization, or the share price times the number of shares outstanding. This is what a company is worth in the market today. Valuation analysis means comparing the market capitalization to various indications of value. It might be a comparison to current and future revenues, earnings, cash flows, asset values, etc.
When we speak of valuation-indifferent investors, we mean investors for whom valuation is
not part of the process. They either will not, cannot, or choose not to consider valuation as a
Will not: Index funds are the most obvious valuation-indifferent investors. In fact, to the extent a stock is overvalued, index funds are required to buy even more of it. Passive investing has become so prevalent that passive index investors are no longer price-takers, buying at the prevailing price set by active investors engaging in a vigorous effort to determine the correct value, but rather price-makers. Their demand sets the price. From our perspective, price-making rather than price-taking calls into question the entire premise of passive investing.
Cannot: A second group of valuation-indifferent investors are the new masses of retail investors, who simply have no training or competency in valuation. Historically, their influence has been limited by stock-brokers or financial advisors who determine suitability and provide advice. Today, no advice or suitability is needed. Download an app and start trading, commission free. Log onto the app and it will give you a “free” share in a highly speculative stock to get you going. Many in this group think an “expensive” stock is one that trades at $100 a share and a “cheap” stock is one that trades at $5 a share.
Choose not to: A third group of valuation-indifferent investors are professional investors who have decided that valuation is not part of the process. As Howard Marks described in his recent memo “Something of Value,” the attitude is to “hold on as long as the thesis is right and the trend is upward.” This investor group thinks it’s unproductive to consider if the market capitalization exceeds even the best case estimates of the present value of future earnings by an order of magnitude. This goes far beyond buying growth at a reasonable price or even growth at any price. It takes the traditional advice of letting your winners run to its logical extreme.
When the last holder of a stock that has valuation as part of the process exits and the shares are held more or less exclusively by members of those groups, the stock becomes disconnected from fair value. Valuation becomes irrelevant and the stock price itself may as well be a random number. The only point in observing that various money-losing companies, without any proprietary advantage, are trading at valuations that imply they will someday become industry leaders, is to marvel at just how speculative the bubble in disconnected stocks has become.
You can read the entire letter here:
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