As 2021 comes to a close we not only wanted to wish all of our friends and clients a merry Christmas and a happy holiday season but also share some thoughts and what we believe to be a helpful perspective in making sense of what hasn’t exactly been a normal year. Let’s dive right into one of the most important concepts we believe will make or break you as an investor – that is, value and price are two different things.
Value is derived from future cash flows over the lifetime of an asset, the risk to those cash flows and then discounting them back to the present. Price is derived from supply and demand for an asset in a marketplace. Value looks intrinsically at the asset to determine what it is worth. Price looks at what others are willing to pay for a similar asset. Value and price in the marketplace will not always agree; they will not always match. There is no rule that says they must harmoniously coexist. In fact, it is this very dislocation that makes a market.
The gap between value and price in the marketplace creates opportunity. This opportunity exists because value – which is not absolute, meaning assumptions and biases are required to arrive at intrinsic value in the first place – conflicts with a marketplace that is fueled by supply and demand, digests world news by the microsecond and is tasked with putting a price, today, on what it thinks of the future. Mood and momentum play a vital role in pricing. We believe the market makes mistakes in this process. How could it not? It is a difficult endeavor to say the least.
With all the above said, in order to capitalize on this opportunity an investor must believe that price will move to value. This assumption is crucial; however, herein lies the challenge – an investor cannot precisely know when, or if, this move will occur. History, as a guide, is very steadfast in its message that over time markets are efficient and price moves to value; nonetheless, it is the unknown time frame and lack of control that allows fear, uncertainty and doubt to creep in and force most investors to throw in the towel. At AIMA, we don’t stress a long-term approach because it sounds good. We do so because it is needed for successful investing. We believe markets are very efficient in the long-run and price will eventually reflect value. On the contrary, it is our belief that markets can be very inefficient in the short-term. Now is one of those times, in our opinion.
Take a look at the chart to the right. There are five stocks that have been carrying the weight of the S&P 500 so far this year. The remaining 493 have had little to no impact, at all, if not negative. The story for the Nasdaq is more eye-opening where the average stock is actually down for the year. When looking at the average stock in the Russell 2000, an index comprised of small-caps, it’s downright ugly; it’s bear country.
So, what has happened? The market has piled into a handful of names it believes are a proxy for safety during these uncertain times. Meanwhile, a large portion of the market is sold off, left outside, not invited to the party. Given the fact the indexes are market-cap weighted (the largest companies influence the index to a greater degree), these mega-caps push the indexes to higher levels when in reality the number of companies actually participating is very low.
Bringing this full circle, the question is, does current price reflect value? In some places of the market pricing appears reasonable but in other spots we believe pricing is irrational due to the fear, uncertainty and doubt the market faces in direct relation to Fed policy, inflationary pressures, bond yields and covid. We believe this dynamic will begin to balance out in 2022 and the market will start sifting through some of the wreckage from 2021 and ultimately reward the companies it mispriced.
In closing, we continue to stress the importance of patience and the perspective that long-term investing requires. Remember, time is the great equalizer and the catalyst behind extracting value from the marketplace.