Source: Global Financial Data
From the Archives
A list of my favorite historical sources for financial history.
While it was a short week in the markets due to the Thanksgiving holiday, this week was particularly busy for me and Investor Amnesia.
Yesterday I turned 25, but more importantly, many of you are already aware that there was a very exciting announcement this week related to Investor Amnesia. If you missed it earlier, on Monday I launched a brand new online financial history course covering Bubbles, Manias & Fraud. The course boasts more than six hours of content split into 37 videos across seven riveting topics like Railway Mania, the South Sea Bubble, Brewery Mania, and more. Students are taught this fascinating material by the world’s foremost investors and financial history experts.
Well I am very happy to say that the launch has been a resounding success. In less then a week, more than 200 students have enrolled in the course and cumulatively plowed through some 800+ lectures. Check out the stellar teaching ‘faculty’ below:
This highly scientific and accurate visual below depicts what Value investors have felt like in recent years.
Well don’t look now, but Value has finally started to not suck. Obviously this is a very short-term bout of outperformance, but in the words of Michael Scott “there is no doubt about it, I am ready to be hurt again.”
Given this change of fortune for Value investing and Small Cap stocks, today’s post will be focused on the history of equity valuation and the philosophy of buying quality businesses at discounted prices. More specifically, this post will dive into some of the history on how investors valued companies in previous centuries, and how this has evolved over time.
For example, the always excellent Michael Mauboussin recently wrote a Financial Times article demonstrating how the rise of intangible investments have impacted popular Value metrics like Price-to-Book:
“Earnings and book value no longer mean what they used to. Tangible assets, such as factories, were the foundation of business value in Graham’s time. Yet intangible spending, such as research and development, has been on the rise for decades. Indeed, companies in developed countries started spending more on intangibles than they did on tangibles shortly after the Fama and French paper was published.
Investments are outlays today in the expectation of higher cash flows tomorrow. Intangible investments are treated as an expense on the income statement. Tangible investments are recorded as assets on the balance sheet. That means a company that invests in intangible assets will have lower earnings and book value than one that invests an equivalent amount in tangible assets, even if their cash flows are identical. Earnings and book value are losing their ability to represent economic value.
Fundamental value investors should focus on gaps between price and value for individual securities. The present value of future cash flows, not misleading multiples, are the source of value. As Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, has said: “All good investing is value investing.” The value factor may be floundering, but value investing remains as relevant and useful as ever.“
A very similar passage to Mr. Mauboussin’s can be found in 1934:
The evolution of Value investing is kind of like History. Markets and environments change, but underlying foundations like human nature do not. The concept of buying securities at cheap prices is literally thousands of years old, as the famous Roman philosopher and statesman Cicero was said to have warned of “[societates publicanorums] shares that had traded at a very high price”.
While the approach to Value investing of a hundred years ago and thousand years ago has obviously needed to evolve, the underlying principle has remained constant. Buy good companies at discounted valuations when the market has over extrapolated short-term information, etc. Just like History does not repeat but it rhymes, Value investing will persist but the way we approach Value must evolve with the times.
Now let’s dive in!
“As the economist Jack Kenneth Galbraith put it:
“Nothing in the nineteenth century is more remarkable than the way men forgot the last railroad debacle and proceeded to lose money in the next.”
After experiencing two railroad booms and busts in three decades, American investors were wary of railroad stocks. With a quarter of the industry bankrupt and leading operators in receivership, their skepticism was clearly warranted.
The great irony, though, was that just when American investors finally learned their lesson in avoiding railroad speculation, railroad stocks went on to post incredibly strong returns as a result of improving earnings and business fundamentals. However, the public’s aversion to railroad stocks was so vehement that even when demonstrable evidence of rising earnings was presented, it fell on deaf ears. Most investors would not dare risk their capital in railroad stocks after 1893. Thomas Gibson, a contemporary investor and author, wrote:
“These opportunities are seldom taken advantage of by the public because of the prejudice and odium inspired by bankruptcy. What the uninitiated fail to see is that bad management, bad financing or dishonest practices, or a combination of these evils, are responsible for receivership in almost all cases, and that a drastic reorganization removes the abuses without curtailing the territory or prejudicing the prospects of the rehabilitated road.”
This prejudice meant investors missed a fantastic opportunity to purchase dramatically improving businesses with steadily rising earnings at cheap valuations. Gibson notes that “both the earnings and the securities of reorganized roads have advanced much more rapidly than those of the sound and solvent properties.”, which is displayed below:
The fiercely negative view of reorganized railroads like the Atchison after 1893 is characterized by one journalist definitively stating that Atchison was “hopelessly bankrupt”. Another article argued:
“The ‘Railroad Gazette’ of New York takes a decidedly unfavorable view of the plan for the reorganization of the Atchison Railway. It objects that ‘the control of the railroad is left in the hands of the two classes of stockholders, the preferred slightly in the majority, but a preferred stock which is not likely ever to earn honestly more than 2% dividends, and a common stock which will never earn anything honestly’… in the opinion of our contemporary, an old-fashioned foreclosure, wiping out fictitious values, would have been the most merciful in the end.”
The bias against railroad stocks became problematic as it clouded investors’ decision-making process since, in reality, Atchison’s reorganization was progressing very well. The company was significantly improving as management cut costs, made routes more efficient by transporting larger loads on fewer trains, and closed redundant lines.
“In the case of the Atchison there was an increase in the year’s traffic receipts of $5,591,000, while the working expenditure was actually $85,000 less than for 1898-1899, the cost of maintaining the road and structures exhibiting a decline of as much as $1,318,000, owing, it is stated, to a considerable reduction in the train mileage, rendered possible by the better loading of cars and the lengthening of trains.”
All this, of course, had a meaningful impact on the bottom line:
There reached a point where investors could no longer ignore the obvious and had to recognize that their prejudice against railroad stocks may have been overly harsh. In 1898, as stock prices began to recover, one commentator stated:
“The upward movement is not at all surprising, for the shrinkage in market valuations from which the rally has taken place was in many cases utterly excessive.”
Railroad stocks crept back into favor and went on a tear from 1898 to 1901. In fact, reorganized railroads were the strongest performers. Gibson wrote:
“As to stock prices, if we assume that about $10,000 was in 1898 devoted to the purchase of either of the two standard dividend-paying roads which were at that time considered the highest grade stocks on the list, as compared with an equal sum placed in the stocks of three reorganized roads, the stocks being disposed of in 1901, we get the following results…”
However, as the author points out:
“If any prophet had been bold enough to suggest in 1898 that Baltimore and Ohio, Atchison and Northern Pacific would in three short years be dividend payers selling around or above par he would have been popularly considered a fit subject for an inquirendo lunatic [lunatic assessment].”
Maybe (definitely) it’s just me, but I always find it fascinating reading the research and analysis of investors from distant periods. The writeups offer great insights on how the investors of a given day thought about their investment approach, and general market conditions. In each period throughout history you tend to see investors weighting specific company attributes or ratios more heavily than others, and it’s interesting to see how these preferences have evolved over time. The From Dividend Yield to Discounted Cash Flow article earlier in today’s post dives into this topic deeper.
This article, however, is an original source from 1939 offering one investor’s research on the persistently lower valuations of American equities compared to their European counterparts.
“Comparison of the valuation of equity capital in the world’s principal markets is significant in indicating the equity share’s relative popularity as an investing medium in economies of different economic maturity. These valuations are measured by comparative earnings and dividend yields, as well as by the relation of these yields to concurrent money rates. Earning power being the underlying basis of shareholder welfare, this inquiry emphasizes the relation of prices to the available profits rather than to the discretionally-distributed dividends.
The ratios of share prices to comparable annual earnings from 1929 to 1937–prior to the extraneous disturbances to prices resulting from recent war factors–of the most important American, British, French, and Dutch companies are calculated. On this basis equity capital has been valued lowest in the United States. It is also shown that, contrary to prevalent assumption, share-price fluctuations have been fully as volatile in London and Amsterdam as in New York. The data further demonstrate that equity capital in America has been consistently priced at the greatest discount from fixed interest capital–that is, that the relative advantage of the creditor status is more lowly regarded abroad.”
The author focuses on a range of ratios and comparisons to illustrate his point, some of which are reproduced below:
He also included earnings ratios for some of the largest companies in each country studied to further demonstrate his point that American companies were trading at discounted valuations.
There is much more to unpack in this article, but I’ll leave you with the author’s conclusions:
“(1) Our samples of equity share valuation in the different countries- as measured by dividend and earnings yields-as well as the comparative ratios of these yields to concurrent money rates, substantiate the impression that equity capital has constantly been appraised lower in America than abroad. In the opinion of the present author, this largely reflects the greater maturity of the European economies and, more specifically, their longer exposure to the following constructive stimuli to share prices:
(a) Progressive corporate seasoning and growth of resources backing equity capital.
(b) Investors’ willingness to pay increasing premiums for proven management efficiency, and for the monopoly attributes of the larger companies (the “blue chip” investing philosophy.)
(c) Investor inertia; reflected, for example, in France, in cumulative disinclination to disturb long-existent holdings even in response to pertinent economic influences.
(d) A diminishing supply of available investment media, including former export outlets for capital.
(2) Our data confirm the existence within countries of a secularly falling preference for fixed-interest over equity capital. While this trend has undoubtedly been largely attributable to the equity share’s growth in absolute popularity, it has probably been importantly accentuated by the persistent encroachment of various political and economic elements-such as the cumulative undermining of the legal rights of the creditor class, the universal loss of monetary stability, and a falling interest rate-on the status of the rentier.
(3) Our comparative analysis suggests that a long-term rise in the valuation of American equity capital in terms of earnings and dividend yield as well as in relation to fixed-interest securities, may well accompany further maturing of our national economy.”
The linked post goes into much more depth on the takeaways below, but here are the 5 main conclusions investors can draw from this extended history on the Value factor:
The -59% value crash as of March 2020 is on the very extreme side of an almost 200 year history.
Without the help of long history, and before the current drawdown, investors might have mistaken value investing as safe.
1940 to 2006 was an exceptionally safe period for value investing compared to its full history. And this tailwind helped many great value investors, creating unrealistically high expectations for value investing.
Value investing, like any investing, looks like a never-ending series of drawdowns, with tiny intervals of absolute gains in between.
So here we are, in a very different time and economy, and value crashed again.
From Dividend Yield to Discounted Cash Flow: A History of UK & US Equity Valuation Techniques (1931)
As I referenced earlier, there have been a wide range of preferred financial metrics and ratios that investors have used to determine what is and what is not a suitable investment for their portfolio. This insightful article covers the progression of these approaches beginning all the way back in 1720 during the South Sea Bubble.
“Equity valuation techniques have a long and varied history, from the South Sea Bubble era in the early eighteenth century, when concepts of capitalizing dividend income and estimating intrinsic value were well understood, to today’s emphasis on earnings and discounted cash flow. This paper examines the history of equity valuation in the UK and the US, from its early origins during the South Sea Bubble, through the early nineteenth century railway boom, the new issue waves of the late nineteenth and early twentieth centuries, the stock market boom and bust of the 1920s and 1930s, right up to the ‘nifty fifty’ boom of the late 1950s and 1960s.
The empirical material consists largely of British and American text books, pamphlets and periodicals of the nineteenth and twentieth centuries, company accounts and prospectuses, and early broker research. As well as offering a description of equity valuation techniques up to the late twentieth century, the paper attempts to explain why investors switched over time from one method to another. We concentrate here on investors investing for the relatively long term. There is also a history of speculation, more prevalent in the US than the UK, and limited use was made of valuation tools for this purpose. Hearsay, insider trading and even market rigging were the means used to achieve a capital gain.”
The article also discusses some of the peculiarities and intricacies that developed along the way as investor’s approaches evolved. For instance, in the late 19th century and into the 20th century there was a divergence between British and American investors in how they viewed the role of dividends / equity in stock valuations.
“The first equity valuation techniques used were dividend yield and book value, reflecting early equity investors’ perception of shares as quasi-bonds, differing only from bonds in the uncertainty of their maturity and of their dividend payments. This approach lasted on both sides of the Atlantic until the Wall Street boom of the 1920s, which had a fundamental influence on American investors’ attitudes to equities. Works by authors such as Smith (1925) and Fisher (1930) exploded the myth that equities were simply riskier forms of bonds. By the 1920s, there were a sufficient number of companies with a sufficiently long life to be able to work out that these survivors’ earnings had grown out of all proportion to their dividend payments. This meant that retained earnings could be reinvested to yield even larger earnings in the future. As far as the Americans were concerned, the role of dividend yield in equity valuation was dead.”
“We focus on the economies of the North Atlantic Core during the nineteenth and early twentieth centuries and find that an impressive variety of local financial institutions emerged to supply the needs of SMEs wherever there was sufficient demand for their services. Although these intermediaries had significant weaknesses, they were able to tap into local information networks and so extend credit to firms that were too young or small to secure funds from large regional or national institutions. In addition, by raising the return to savings for local households, they helped to mobilize significant new resources for economic development.”
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