Financial Perspectives Blog
Based on 6/7/2021 Firm Foundation vs. Castles in the Air
“The greatest of all gifts is the power to estimate things at their true worth.”
La Rochefoucauld
If an investor could discover the true worth of a company, a piece of real estate or even an idea, where “true worth” equated to the future value or price that others would pay, success would be almost certain to follow. Those opportunities that were priced significantly lower than the future value would be automatic buys. The one’s with higher prices today than the future price would be ones to avoid. If only it were that simple! Valuation questions many investors are asking today sound like, “What is bitcoin worth?”, or “What’s the right price for shares of Tesla, or AMC?”
Professional investors and academics have developed many valuation theories through the years. In his classic book “A Random Walk Down Wall Street,” Princeton finance professor and author, Burton Malkiel, has divided the theories into two general categories, Firm Foundation and Castles-in-the-Air.
Firm Foundation theories lean toward tangible measures of value based on current data like cash flows, profits, book value, cash on hand, dividends, and interest payments. This is the kind of data that can be found on income statements and balance sheets. The Firm Foundation approach appeals to the hard worker, the data driven researcher. Many academics and legendary investors like Benjamin Graham, Peter Lynch, John Bogle, Warren Buffett and Howard Marks, fit in this category.
The term “Castle-in-the-Air” applied to investing was made popular by John Maynard Keynes (1883-1946), who was more famous as an economist but was also a successful investor in his day. Rather than relying on tangible metrics, Keynes and others thought that investors built narratives, Castles-in-the-Air with little to no foundation, that caused them to think that the price of something would rise in the short-term, regardless. That, in turn, allowed them to buy today at a low price and sell tomorrow at a higher price. This approach focuses on the psychology of market participants and, today, is a subject of intense research within the field of behavioral finance. The statement, “A thing is worth what someone else will pay for it.” captures the idea well. Instead of intrinsic value, the worth of something is determined solely by what it can be sold for.
Some well-known Firm Foundation approaches include the Dividend Discount Model (DDM), as well as ratios, like Earnings Per Share (EPS) and Price to Earnings (PE). Not all measures work for every investment. For example, Amazon does not pay a dividend currently, so the DDM, by itself, would say Amazon’s stock is not worth anything. But, when you own shares in a company like Amazon, you own a pro rata share of the firm’s earnings, whether it is paid out as a dividend or reinvested to enable the firm to grow. Amazon’s EPS was over $52/share on June 4, 2021, and their PE ratio was just over 61.1 With Amazon’s history of growing earnings, Firm Foundation investors have good reason to think the mega-company has very positive intrinsic value.
How does the Firm Foundation Theory work with a company like AMC, the movie theater operator? The company has been in the news a lot this summer as traders who frequent websites like Reddit and Robin Hood have promoted buying the stock. AMC has not turned a profit since 2018 and lost $39.15 per share in 2020.1 On a balance sheet basis, the firm swung to negative shareholder equity in 2020, meaning there were more liabilities than assets. According to these kinds of measures, it’s hard to find intrinsic value. And yet, AMC’s stock price is up 863% in the last twelve months.1 How can this be?
This is where the Castles-in-the-Air explanation comes in. While there is arguably not a fundamental reason for the stock price to go this much higher today, market participants are speculating that the stock price will go higher tomorrow. Why do they believe this? The story being told around the stock, the narrative, is convincing. This kind of speculation does not depend on intrinsic value but rather relies on positive price momentum, so that the buyers today can sell tomorrow, or at some time in the near future, at a higher price.
Bitcoin is an even clearer example of a Castle-in-the-Air narrative and subsequent speculation or investment. Bitcoin pays no interest, has no earnings or book value, and it is not a tangible asset. Unlike gold or other commodities, you can’t eat it, fuel a vehicle with it, or build something with it. And yet in the past 12 months, bitcoin has risen in price over 280% even with the recent pullback from its April 2021 highs.1 Why? Like AMC, the story, the narrative about the need for a digital, anonymous, non-governmental currency, a new form of payment, is compelling to many. And, because that narrative has created an upward trend in crypto currency prices, speculators, as well as believers, are buying and selling, convinced that the price will be higher in the future than it is today.
Are all investments with a “Castle-in-the-Air” story and lack of intrinsic value doomed to failure? History would say no. Amazon in the early 2000’s had little to no intrinsic value for a number of years. And yet, the underlying value of the company finally caught up with the story, as Amazon grew to be one of the biggest and most profitable companies in the world. From a money losing online bookstore to a retail, logistics and web technology giant in less than 20 years, Amazon has survived and prospered. However, the success stories are easy to see, while hundreds of failures tend to recede in the public’s memories. Many dot com companies went bankrupt in the early days of the internet. Electric vehicle companies, like Lordstown Motors and Nikola, have seen temporary upward price spikes followed by steep declines, while Tesla has seen its stock price grow dramatically and is now turning a profit.
Portfolios that are relied upon for critical financial goals like retirement security, whether held by individuals or institutions, likely need to have a large majority of their holdings invested in assets with Firm Foundations. Assets that provide consistent cash flows of interest and dividends, as well as shares of companies that are profitable and have positive book values, are good examples. Financial markets today allow investors to cost effectively hold broadly diversified portfolios of these Firm Foundation assets all over the world.
Someone is always constructing new Castles-in-the-Air and some will make the transition to Firm Foundation. A few will even become wildly successful and have staying power. Others will appear for a while, gather a lot of attention, and then fade away. Early adopters who “know” or guess well on when to buy and sell, may do well in the short-term, while others who get in too late will suffer large losses.
For investors with a desire to speculate and who find castles with stories that make sense, we recommend that you only risk capital that you can afford to lose, a small percentage of the overall portfolio. If some of your picks turn out to be Amazon or Tesla, you’ll have a great story of your own to tell. If some turn out to be long-forgotten dot coms or dry oil wells, your more important plans will not have been derailed.
1https://ycharts.com/