Sunday, June 1, 2014

Charles Neuhauser meets the Asch Paradigm

"Never overpay for stock. More money is lost than in any other way by projecting above-average growth and paying an extra multiple for it"
Charles Neuhauser, Bear Stearns

This has always been one of my favorite quotes, and I think it's one of the most relevant thoughts I've ever come across. Of course these days, valuation and fundamentals have been thrown into the back seat as other factors are currently influencing the market's direction. But, valuation - what you pay for the companies you buy - is always important. No matter what is going on in the short to medium term. 

With that in mind, I wanted to give an example of what I'm struggling with regarding current stock valuations, and then tie that into Asch's paradigm in an effort to show how the financial industry gets itself into trouble from time to time. 

So I thought I'd pick a company whose business I like, but am wary of the valuation. A name that everyone knows, and that has a great global brand: Proctor & Gamble (NYSE: PG). I like the company because of it's incredible stability. It's paid a dividend every year since 1890, and has raised its dividend for 58 years in a row. The company boasts an incredible brand - selling products under the names Tide, Gillette, Pampers and Crest. 

At the time of writing this post, PG shares were sitting at $80.79 - (link for current quote here)

So a quick look at Valueline shows 2014 actual earnings were $4.05 - which suggests PG trades at 19.94x 'trailing earnings' -

Sidenote: See, way way back when I started in the business (1993) all PE ratios were based on trailing earnings, as those were the earnings actually earned and recorded into the books. The 'forward earnings' references started a few years after I started. Initially research pieces quoted forward earnings only going out a year into the future, but as the practice took root, it's now not unusual to see estimates going out three years. We will get back to this on the second part of the discussion. 

If the earnings for PG in 2014 are expected to come in at $4.30, and 2015 at $4.60, then PG is said to be trading at 18.79x 2014e EPS and 17.56x 2015e EPS. See? Doesn't the idea of paying 17.56x to buy PG sound so much better and more reasonable than buying it at 19.94x?

Now, here is where Neuhauser's comments come into play.

An increase in earnings from $4.05 to $4.30 is 6.17%, and an increase from $4.30 to $4.60 is 6.97%. In its most simple form, value investing is when you are buying a company at a cheap price relative to its earnings growth rate. Using a PEG ratio measure (a ratio of PE ratio divided by a company's earnings growth rate) the goal is to buy a company under 1.00 - that is, you are buying a company whose PE ratio is less than the earnings growth rate of the underlying company you are buying. 

Unfortunately in the case of PG at its current price - we are no where close to that kind of valuation.

PG's PEG ratio is sitting at 3.04x for 2014 (18.79 divided by 6.17) and 2.52x for 2015 (17.56 divided by 6.97)

Not cheap. 

Now - there are a MILLION different ways to evaluate a company's worth that are more sophisticated that have merit and are worthy of your consideration - but I am using the PEG to show you what Neuhauser was talking about. 

Remember what Neuhauser said.. "Never overpay for a stock. More money is lost than in any other way by projecting above-average growth and paying an extra multiple for it"

What does he mean by that? 

Well in the case of our current example with PG, if we look at the company's compound growth rate (CAGR) in earnings from 1998 to 2015 (using current estimates) we find that PG has grown earnings at a rate of 7.82% per year - Pretty outstanding for a firm this mature. 

But, if we buy the stock today at 19.94x trailing or 18.79x 2014's expected earnings, we are also breaking Neuhauser's timeless rule. This is where the financial industry can get itself into trouble. 

Let me give an extreme example - if the PEG ratio on PG was 1.00 and reflected the company's average annual compound earnings growth rate from 1998-2015, the stock would be trading at $33.63, down over 58% from its current level. 

recall: PEG ratio = PE ratio divided by Earnings growth rate. 

SO to a 'strict Neuhasian valuation' would suggest a PE ratio of 7.82x on 2014e EPS of $4.30 - so 7.82 x 4.30 = $33.63  

Even a less extreme compression in multiples suggests a big decline in the price of the stock. Assume for example that PG's current trailing PE ratio only fell from 19.94x to 18x. In that case, the stock would move from $80.79 to $72.92.

I would suggest that investors also be very mindful when they see a stocks target price increase solely on the back of an increase in the assumed multiple.

An example of what I mean:

Assume XYZ Brokerage Firm initiated coverage on the company in October of 2013 at $76.00 with an $80.00 target price. As the price rises closer to the target price and the overall market environment is still bullish, it is not uncommon for a target price to get bumped up. But, there are times when instead of earnings assumptions increasing - from say $4.30 to $4.45 for 2014 - the analyst just tweaks the assumed multiple. In this case they'd say something like:

We are increasing our 12 month target price on PG from $80.00 to $88.58. We continue to think PG will earn $4.30 in 2014, but think a more appropriate multiple is 20.6x earnings and not 18.6x.

So, even though the earnings estimates haven't increased, the firm has managed to bump up the target price by over 10%.. ta da!

I for one am very wary of multiple expansion assumptions on stocks (to increase a target price) as there is no way to verify what 'exact' multiple is appropriate.

And this brings me to the second part of my post.. the Asch Paradigm.

I always found this experiment kind of interesting -

from wiki:

Male college students participated in a simple "perceptual" task. In reality, all but one of the participants were "confederates" (i.e., actors), and the true focus of the study was about how the remaining student (i.e., the real participant) would react to the confederates' behavior.

Each participant was placed in a room with seven "confederates". Confederates knew the true aim of the experiment, but were introduced as participants to the "real" participant. Participants were shown a card with a line on it, followed by a card with three lines on it (lines labeled A, B, and C, respectively). Participants were then asked to say aloud which line (i.e., A, B, or C) matched the line on the first card in length. Each line question was called a "trial". Prior to the experiment, all confederates were given specific instructions on how they should respond to each trial. Specifically, they were told to unanimously give the correct response or unanimously give the incorrect response. The group sat in a manner so that the real participant was always the last to respond (i.e., the real participant sat towards the end of a table). For the first two trials, the participant would feel at ease in the experiment, as he and the confederates gave the obvious, correct answer. On the third trial, the confederates would all give the same wrong answer, placing the participant in a dilemma. There were 18 trials in total and the confederates answered incorrectly for 12 of them. These 12 were known as the "critical trials". The aim was to see whether the real participant would change his answer and respond in the same way as the confederates, despite it being the wrong answer. Once the experiment was completed, the "real" participant was individually interviewed; towards the end of the interview, the participant was debriefed about the true purpose of the study. Participants' responses to interview questions were a valuable component of Asch's study because it gave him a glimpse of the psychological aspects of the experimental situation. It also provided Asch with information about individual differences among participants.

the results? 

Overall, in the experimental group, 75% of the participants gave an incorrect answer to at least one question.

worth watching the video here -

Those work work in the business may never have heard of the "Asch Paradigm" before, but they are very familiar with its influence in the investment world.

Investment guru Jeremy Grantham summed up Aschian influences very effectively in his recent quarterly note entitled, "My Sister's Pension Assets and Agency Problems"

he said,

"The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest."

and slightly shorter but very commonly used Aschian mantra in the investment world is

"Don't fight the Fed"

Peter Tchir of Brean Capital posted a wonderful article on Zerohedge this morning called,

that hints at the same Aschian phenomenon of conformity going on with the Fed's GDP forecasts. Peter's article is a 'must read' as he rightly questions how the Fed can justify its' call for strong future growth given the volatility we've seen in other economic data points to date.

So what to make of this post?

Well the market is continuing it's run higher, of that there is no debate. But, as Charles Neuhauser warned, more and more people are assuming an above average growth rate and then tacking on a few extra points to the multiple when they buy. The narrative of the day is that growth is getting better, and that escape velocity is 'right around the corner', but this narrative has been running in a similar fashion for the last five years. Maybe, just maybe we are seeing yet another example of what Asch discovered in his experiment and Jeremy Grantham mentioned in his letter.

Just ask yourself what happens to share prices if stock multiples start to reverse course and compress? What happens if PG's PE ratio falls from almost 20x to 12x (which as we know is still above it's longer term CAGR)? What happens if you find out the conformist's narrative was wrong?

Sure there are lots of different ways to value a stock and account for the rise we are seeing (PEG is obviously a very simple valuation method) - but that's entirely my point: When it comes to investing, you need to think for yourself and don't never fall victim to a conformity trap.

Just something to consider -