Jonathan Marriott, Chief Investment Officer
I recently had a cold call pushing a cryptocurrency dealing service. They clearly had no idea what I do for a living and tried simply to tell me “how much money I could make”. I suggested that there was no real value in Bitcoin and was told that since the price had gone up so much it must have value. This made me consider if there was a difference between value and price. This may seem a semantic argument, but as investment managers we are always looking for where the price is below where we consider the value to be. In other words, something we see as cheap. When we supply a portfolio valuation we show the market price of assets, if we are doing our job properly then the value should be higher than the price; hence the price increases over time.
So, what is value? For a financial asset it can be seen as the present value of future cash flows adjusted for uncertainty about those cash flows. The present value is calculated by discounting cashflows at an interest rate. The starting point for this calculation is a so called ‘risk-free rate’ such as US Treasuries for dollar denominated assets. With the perennial debt ceiling debate some would not consider even this to be risk free, but this is the best starting point we have. This rate may be adjusted upwards to reflect the potential risks. The market price is the price both a buyer and seller can agree on. If something is in limited supply and two people want it, the price will go up until one of the two cannot afford it. Perhaps an extreme example of this was Leonardo da Vinci’s Salvator Mundi which fetched $450million at auction in 2017, even though some experts questioned both the quality of the painting, and whether it was painted by the hand of Leonardo. However, there are very few pictures by Leonardo left in private hands and two buyers with enormous resources wanted it. While its price remains $450m, its resale value may be something completely different if it were to come to market again.
When investing client money and assessing value we look at assets that are less speculative and we hope more predictable. When assessing cash flows we could look at dividends but these just represent the amount a company chooses to pay out to shareholders. A company may also buy back shares which also benefits shareholders. However, the underlying cash generation is a far better representation of the value added by a company’s operating business. This may be impacted by future sales and indirectly by broader economic conditions but in assessing the predictability we look at the risks to those cash flows. Here we look at the ‘moat’; that is how well is the company protected from competition and how big are the barriers to entry? This is to some extent subjective and where the skill of the analyst comes into play.
So, when assessing the valuing of any asset we combine qualitative judgement with quantitative analysis. We can then compare our assessment with the market price. All too often we are told what a great business a company is, and how much it will grow, but if the price is not right then it should be avoided. When it comes to assets without any cash flows the valuation is entirely subjective and purely a matter of supply and demand. Commodities such as oil are a case in point; restrict production and/or increase demand sees the price rise fairly rapidly. Eventually producers increase production and a new equilibrium will be established. Last year during the pandemic demand collapsed, and the price fell dramatically. Production was cut and as demand has picked up the price has risen again. If OPEC increases production the price will no doubt fall again.
Other assets such as art are much harder to value still and subject to taste. Twenty years ago the prices of 19th century landscapes were on the up and I bought one for £3,000 which was later valued at £20,000. Today it is all about modern art and the painting I bought is worth little more than I paid for it. There are a limited number of 19th century paintings, but limited supply does not mean the price cannot go down. I frequently get told that cryptocurrencies will go up forever because supply is limited, those playing in this market should remember that demand is as important as supply. Regardless of its monetary value, I value seeing that painting hanging on my wall.
I am sometimes accused of spending too much time looking at the future of interest rates, but this has a bearing on all the investments we make and is key to any quantitative valuation. It may also impact the consumer behaviour and economic growth. Assets without cash flows, such as art and bitcoin, we will leave to speculators and not consider for client portfolios.
To go back to the question; the price represents what someone else will pay and may be far from the real value of an investment. Investors attracted by fashionable trends should remember this. However, we also need to remember the old maxim that markets can remain irrational longer than you can remain solvent. So, while ignoring a trendy investment may be wise, actively betting against it has its dangers as well.
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