Bad Theory? Or Bad Practice?

Griffin dissects Byron Wein's valuation model in the framework of the market now.
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The battle-scarred veterans would smile whenever a newbie in our economic theory seminars would, in the heat of debate, blurt, "That's fine in theory, but it won't work in practice." Our professor would lie in wait for that line. "If it won't work in practice," he'd fire back, "it won't work in good theory."

Please don't test me on what else I recall from those discussions, but that particular image is indelible. The circumstance that sparked this recollection was

Byron Wein's

re-examination of his trusty valuation model. The

Morgan Stanley

strategist is in the top rank of his profession and his model is a time-tested one that estimates "fair value" on the basis of two key variables: the expected earnings growth rate and an appropriate discount rate. It's simple, straightforward and perfectly sound in established theory. But it hasn't worked lately in practice. Something is out of kilter. Do we need new theory? Or different practice?

It is widely accepted that a fair price for a security is the discounted present value of the future stream of payments it commands. The higher -- or faster growing -- the stream of payments and the lower the appropriate discount rate, the more valuable the security. Byron's model mechanizes these concepts and enables him to plug in alternative estimates of growth rates and discount factors in order to simulate reasonable market response to changing business and financial conditions.

Obviously it is not possible to know what those payment streams and discount rates will actually prove to be. But we can each plug in our own estimates for these variables and then trade with others in the marketplace whose best guesses produce different judgments than our own. When market prices are so high as not to be justifiable within our own perceptions of appropriate growth or discount rates, we'll tend to move to the offer side of the market. That's a prudent strategy. It has also been the wrong thing to do, as this seemingly overpriced market has consistently moved higher.

So maybe we have bad theory here, embodied in model's like Byron's that relate growth and discount rates and have, until recently, proved to be highly useful in valuation judgments. Maybe we need a new framework for thinking about value. Or maybe we are making the simple mistake of using bad estimates for the model's inputs -- we are too conservative in our assumptions about growth and discount rates. Or maybe there is nothing wrong with the model or the inputs to it -- maybe the problem lies not with the theory but with the practice. If we are convinced it is good theory, then the fact that it won't work in practice may mean that it is bad practice.

One guidepost for practical stock-picking that is rooted in this growth rate/discount rate framework is that one should not pay a price-to-earnings multiple for a stock that is significantly higher than its earnings growth rate. The value instinct requires that the so-called PEG ratio, or P/E-to-growth rate, should not be in excess of one. That may be a sensible idea, but it has been a losing tactic: a PEG ratio discipline has long since kept you out of the stocks that have been working. For that matter, it has kept you out of the market entirely: the P/E ratio for the broad market, using either the

S&P 500

or the

NYSE Composite

, is in the high 20s. The earnings growth rate is nowhere near that high.

Or is it? I don't know what the market's earnings growth will turn out to be, but I doubt it will be 25% or more. What's your guess? The market is telling us that earnings growth will be a lot higher than the numbers that analysts and strategists have the nerve to publish. Or it's telling us that the discount factor that we're using is inordinately conservative -- we have been too bearish about inflation and interest rates and the risk premium that is appropriate in current and prospective circumstances.

Inflation may indeed be dead, and today's so-called real interest rates are still too high because they adjust with a lag that is a function of the time it takes to teach people like me that old rules don't apply. Maybe the prospective shrinkage in

U.S. Treasury

supply will so open up the market for fixed-income securities that bond finance will become much cheaper in the years ahead than it is now.

The investment world may indeed be a much less risky place, with less volatile business cycles, calmer markets for commodities and foreign exchange, more sensible fiscal and monetary policies, broader participation in and deeper liquidity of financial asset markets. But in a world of breakneck change, of technology revolutions, a world in which speed trumps mass, it seems imprudent to slash deeply into one's risk premium estimate.

It makes sense to me that if the future proves that today's optimistic outlook for the federal budget is accurate, then the "risk free" rate that clears the market is likely to be lower than it is today. If credit risk spreads turn out to be the same as today's, or especially if they are lower, then the cost of bond finance for established firms will decline and such firms will cede the markets for equity capital increasingly to start-ups that can't access the cheaper spigot. Over time, that may tend to create a capital structure that responds in a volatile manner to changes in business conditions, which may have the effect of causing the market to boost its required risk premium.

That process may already be at work today. It is difficult for me to imagine the kind of rationalization that went on behind the faces of those who bid up last week's IPOs of

VA Linux Systems

(LNUX)

and

FreeMarkets

(FMKT)

to seven-fold and five-fold gains, respectively, in the first day of trading. FreeMarkets' underwriters were reported to have been planning, during the prior week, to bring its issue at $16 per share. Instead, it came public last week at $48 per share -- and rose to $248 in its first day of trading. Extract for me, please, the discount rate or earnings growth rate assumptions that justify a competitive bid in that market.

Being too cautious about future growth is a sure ticket to investment underperformance. (So too is over-optimism -- but the timing is different.) Last week's IPO fireworks reminded me of something that used to be called the "reverse yield gap." For nearly three decades, until 1958, investors were so cautious about the prospects for growth that they were unwilling to bid virtually anything at all for it: stocks, the junior securities, cleared at prices that generated higher current dividend yields than their contemporary bond yields. Why pay more for stocks when they are riskier than bonds and probably won't provide any growth anyway? They hadn't in 30 years.

A lot of savvy old-timers didn't catch on that the world had changed in an important way, that their hard-won experience was no longer relevant. What seemed to them at the time to be bad practice, when assessed against what seemed at the time to be good inputs to a good theory, produced results much different than they expected. The old-timers had growth expectations that proved to be way too conservative. Consider those IPO shooting stars last week, which put me in mind of new tricks. And old dogs.

Good theory, bad practice? Bad theory, good practice? Byron's model still makes solid sense to me. I can't understand the framework that justifies the prices bid for last week's new offerings. Maybe my mistake is that I presume there is a framework at all.

Jim Griffin is the chief strategist at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. While Griffin cannot provide investment advice or recommendations, he invites you to comment on his column at

GriffinJ@aeltus.com.