|Montreal, May 15, 2004 / No 142|
by Chris Leithner
Stock brokers, financial advisers and planners, analysts and strategists and commentators and speculators regularly express the opinion that Security X (or market sector or market as a whole) is "undervalued" or that Security Y is "overvalued." But the prominence of value in their view of the world is much more apparent than real: virtually without exception, as a careful reading of their reports and quotes in the media makes plain, their preoccupation – indeed, their obsession – is "the market" and short-term "performance" (see also Leithner Letter 21).
Like most human beings, brokers, advisers, planners and journalists are creatures of habit; as such, they seldom subject their habits to searching scrutiny from first principles. Perhaps for this reason, they cannot recognise that three fundamental assumptions underlie their neglect of value and glorification of price, index, short-term performance and unrealised capital gain. The first assumption is that there exists a one-to-one correspondence between the price and the value of a good, service or security. Value, in other words, is simply an unobserved carbon copy of an observable and objective price. If the price of a steak or a haircut or a stock is $10.00, then its value is also $10.00 – nothing more, nothing less and no doubt about it; and if a price changes by some amount then value changes by an identical amount.
Secondly, goods and services possess an intrinsic and objective property (classical economists from Adam Smith to David Ricardo and Karl Marx nominated their inputs of land and labour) such that their prices (and hence values) can be determined by their cost of production. According to Adam Smith, for example, "labour is the real measure of the exchangeable value of all commodities." Thirdly, equality of value is a necessary condition of the proper exchange of some amount of one given good or service for some amount of another. If their value were not equal, in other words, then they should not change hands.
It follows from the first and second assumptions that the values of different quantities of certain goods can be declared equal to one other. If the price of good X is 0.4286 times the price of service Y, for example, then the value of seven units of X equals three of Y. And it follows from the second and third assumptions that the price of a good or service should approximate what it costs to produce – and if it does not then the exchange is "unfair" because one of the parties is "exploiting" the other. Further, if "proper" trade occurs only when the values being exchanged are equal, then any exchange in which one party is deemed to receive much more value than he gives must be dishonest or otherwise illegitimate – and therefore deplorable and best resolved by legal sanction and (because these days the state must intervene whenever anything is the matter) government regulation.
Ancient and Modern Pedigrees of “Value”
These three assumptions, as Gene Callahan notes in his excellent article "Carl Menger: The Nature of Value," boast a lineage that extends back to Aristotle (see also Hans Sennolz's preface to Eugen von Böhm-Bawerk, Value and Price: An Extract from Capital and Interest, Libertarian Press, 1960, 1973). Above and beyond their troubling consequences, Callahan also notes that they are circular. If, for example, the value of a personal computer depends upon the labour and materials required to construct it, and if the value of these materials depends upon the labour and other materials required to produce them, then how does one determine the value of that labour? If the value of a kilo of apples depends upon the value of the labour and land that produced it, then how does one ascertain the value of farm labour and land?
Classical economists implicitly recognised but ultimately failed to resolve this difficulty. According to Karl Marx, only "socially valuable" labour determines the value of goods and services. By what criterion do Marxists characterise labour as "socially valuable"? The "social value" of the goods it produces! Hence the vicious circle the classical economists could not resolve (and which continues to bedevil parts of contemporary mainstream economics and finance): the value of goods and services derives from the value of the capital, labour and land required to produce them; and the value of that capital, labour and land depends upon the value of the goods and services they produce. Given this circularity, it is no wonder that the typical broker or financial planner is more than happy to talk interminably about the price of a security – but suddenly turns mute when asked to define and justify its value.
The founder of the Austrian School, Carl Menger, demonstrated that the conceptions of value and price adopted by Aristotle, the British Classicists, Marx and their contemporary mainstream progeny are muddled and mistaken. So too, in important ways, are contemporary mainstream views about the market and exchange in the market. To regard value and price as synonyms is to introduce a circularity into one's reasoning that leaves these concepts unexplained – and may render estimates of value and negotiations of price prone to error. Menger hardly intended to overthrow classical economics. He applauded its emphasis upon universal and immutable economic law and the laissez-faire policy conclusions derived from these laws. Menger sought to reconstruct classical economics by grounding laws of supply and demand and the theory of monetary calculation in the choices and actions of consumers.
It is interesting that Menger, William Stanley Jevons and Léon Walras uncovered very similar principles (such as subjectivism and the law of diminishing marginal utility) separately and almost simultaneously. Neoclassical economics builds upon the stones laid by these three founders; yet the efficient markets hypothesis, modern portfolio theory and the like, which are close relatives of modern neoclassicism, utterly ignore Menger and the Austrian School. It is also interesting to note that Grahamite value investors, reprobate dissenters from the contemporary mainstream, pay much more attention to value than does the mainstream (see also "The Meaning of 'Over-Valued'" by Christopher Mayer). Value investors think about value in terms that are not Austrian but are nonetheless much closer to Menger than Aristotle.
Anticipating the assessment of John Burr Williams (A Theory of Investment Value, Fraser Publishing Co., 1938, repr. ed. 1997) that "separate and distinct things not to be confused, as every thoughtful investor knows, are real worth and market price," Benjamin Graham (Security Analysis: The Classic 1934 Edition, McGraw-Hill, 1996) held that price is what is paid and that value is what is received; observed that over time price and value tend to gravitate towards one another but that at any given point in time they may diverge (sometimes by a wide margin); and lamented that very few people recognise the fundamental difference between value and price. It is this vaguely-Austrian conception of value and price that ultimately distinguish Graham and his successors from the contemporary mainstream. Value investors, as practitioners of Graham's principles are often called, thus reject today's dogma that the price and value of a security necessarily coincide at all times.
Carl Menger and the Intelligent Investor
A price is a ratio at which the "most eager" buyer(s) and "most eager" seller(s) voluntarily exchange some specified good, service or commodity. A buyer is "most eager" in the sense that (s)he is willing to exchange it for the greatest amount of some other commodity such as money. A seller is "most eager" in the sense that (s)he is prepared to accept less money for it than is any other seller. Hence a security's least optimistic present owner and most optimistic non-owner determine its price. In John Burr Williams' words, "the margin will fall between owners and non-owners, the in and outs, the ayes and nays; and at this margin, opinion, mere opinion, will determine actual price."
The price of a stock, bond or other security at any point in time is determined by marginal opinion at that time. It follows that a particular price is unique to a given buyer(s) and seller(s), the security being exchanged, their attitude towards it and their information about it. All of these determinants of a security's price are subject to sudden and unexpected change; accordingly, so too is its price. A stock's price may, in other words, tell us something about the value imputed to it by an eager buyer and eager seller at 11.00 on Monday 15 March; but it tells us nothing about the value attributed to it by other owners and by non-owners. Still less does it tell me the value I should impute to it. A stock's price and its value, then, are very distinct things; in any given exchange the one will not equal the other; and current price may differ greatly from my estimate of its value.
Only if the current price differs considerably from my own assessment of its value and no better investment opportunity presents itself does this price give me an incentive to act. According to Warren Buffett (Forbes, 4 January 1988), "the market is there only as a reference point to see if anybody is offering to do anything foolish." Mr. Buffett added (The New York Times Magazine, 1 April 1990) "for some reason, people take their cues from price action rather than from values. What doesn't work is when you start doing things that you don't understand or because they worked last week for somebody else. The dumbest reason in the world to buy a stock is because it's going up."
The price of a stock or bond, then, is determined by marginal opinion. But opinions are not facts, and the opinions of marginal buyers and sellers are not necessarily informed opinions. Market participants, in other words, are neither omniscient nor prescient. James Grant puts it tartly in Minding Mr. Market: Ten Years on Wall Street With Grant's Interest Rate Observer (Farrar, Straus & Giroux, 1993): "to suppose that the value of a common stock is determined purely by a corporation's earnings discounted by the relevant interest rates and adjusted for the marginal tax rate is to forget that people have burned witches, gone to war on a whim, risen to the defence of Joseph Stalin and believed Orson Welles when he told them over the radio that the Martians had landed." (see also William Sherden, The Fortune Sellers: The Big Business of Buying and Selling Predictions, John Wiley & Sons, 1997)
The next time somebody tells you with a straight face that all investors have the same information, expectations and time horizons; that markets are very liquid, making transaction costs so small that they can be ignored; and that value and price are synonyms, the sane response is to laugh. The core of value investing, in the words of Benjamin Graham (widely regarded as the founder of modern financial analysis) is the contention that "investment is most successful when it is most businesslike." This focus upon businesses, their economics, operations and results – and not "the market" – permeates value investors' assumptions, reasoning and behaviour. It also forms the basis by which they measure the results of their investment decisions. Value investors think first about value and then about price, and they do so in terms that are not Austrian but are nonetheless much closer to Menger than Aristotle. The volatility of a company's stock has nothing to do with its operations and financial results. For this reason it plays no part in any rational assessment of its value.
Yet for the vast majority of brokers, advisors and speculators-who-think-they-are-investors, prices and short-term fluctuations are the be-all-and-end-all. The greater the short-term increase of a security's price, the more favourable their evaluation of its "performance"; conversely, the smaller the rise or the greater the decrease the more negative the interpretation. And if Asset A or Index A increases relative to Asset B or Index B, then A has "outperformed" B.
From the point of view of a value investor, this pervasive "double-barrelled foolishness," as Robert Hagstrom called it in The Warren Buffett Portfolio (John Wiley & Sons, 2000), is not only counter-productive – at times it is also dangerous. It encourages people to check stock quotes every day, to rejoice when prices rise and fret when they fall. It also prompts institutions with responsibility for billions of others' savings constantly to buy and sell, churn assets at dizzying rates and generate appreciable transactions costs – i.e., to do everything except act as capitalists making justifiable estimates of value.
The mainstream's genetic disposition to neglect value and glorify price, index, short-term performance and unrealised capital gain, which stems from Aristotle and culminates in the "twaddle" and "dementia" (as Charles Munger, Vice-Chairman of Berkshire Hathaway, has denounced it) of contemporary mainstream finance, is the principal reason why speculation is typically far more prevalent than investment on financial markets. This genetic predisposition and the behaviour it spawns is a big reason, as many briefly learnt during 2000 and may have to relearn, Why Speculation Inevitably Ends in Tears.
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