What the hell is water? What is intrinsic value?

Graham Hand, Editorial Director at Morningstar, has an interesting analogy to put you on guard.
By Morningstar |  18-07-21 | 

David Foster Wallace was a brilliant American writer and satirist. In a commencement speech to Kenyon College graduates in 2005, he gave a parable about the difficulties of daily life:

There are these two young fish swimming along, and they happen to meet an older fish swimming the other way who nods at them and says, ‘Morning, boys, how's the water?’

And the two young fish swim on for a bit and then eventually one of them looks over at the other and goes, ‘What the hell is water?’

... The point of the fish story is merely that the most obvious, important realities are often the ones that are the hardest to see and talk about ... A huge percentage of the stuff that I tend to be automatically certain of is, it turns out, totally wrong and deluded."

Although Wallace did not specifically speak about investing, it is equally applicable in 2021. The traditional fundamental investment analysis, such as taught to the high levels of a CFA, or Chartered Financial Analyst, uses many ways to value a company based on metrics. These include Price to Earnings (P/E) ratios, Return on Equity, Price to Book (P/B), dividend payouts, market beta, and on it goes. Combined, they help an analyst to derive an intrinsic value of a company which can be compared with the current share price.

What the hell is water? What the hell is intrinsic value?

We are now investing with increasing disconnects between this fundamental analysis and what some players, young and old, are willing to pay for a wide range of assets. More than ever, even in the dotcom boom, we have some fish saying the water is obvious, like the intrinsic value of a company. And we have other fish who not only ignore these traditional metrics, they are not even in the same fish tank.

The best examples of the excesses are ‘meme stocks’. Even the people who buy them struggle with a definition. Apparently, you recognise them when you see them, or 'they just are'.

According to Urban Dictionary: Any publicly-traded company stock that keeps going up and disregards the fundamentals such as revenue and profits when valuing the underlying company ... Due to hype around the company and its future outlook, the price of their stock keeps going up beyond a point that makes logical sense which may or may not result in a steep drop later on once/if the hype dies down.

The prices are often driven by platforms such as Reddit, TikTok and Robinhood, in a social media barrage of self-reinforcing chat. If a stock is $10 today and everyone is talking about it, then it will probably be worth $15 tomorrow and $20 or $100 in a week. The best example is GameStop in the U.S. which went from $20 to almost $500 in a month at the start of 2021. The surge had nothing whatsoever to do with the company’s ‘value’. On social media, young guns boasted of their rapid money-making and their friends drowned their FOMO by piling in. The miracle turned water to wine.

Morningstar Chief U.S. Market Strategist, David Sekera, said this about investing in memes, but the lesson is valuable for any stock investor:

  • Why are you buying?

Part of the reason meme stocks have risen in the first place is FOMO, or Fear of Missing Out, which is fuelled by too many people touting about how much money they are making on these trades.

  • Are these investments?

These situations are not what we consider to be an investment but are short-term momentum trades, meaning that the stocks are not moving due to changes in the underlying fundamental value of the company but are based on technical indicators. Do not buy into the mania. It should be contained within the realm of day-traders who are willing to speculate on momentum. Do read: Want to speculate? Do this first.

  • Do you understand short selling?

These situations often start with a short squeeze, and then turn into a self-fulfilling prophecy in the short run on the way up. But once the upward momentum runs out and stocks start to turn down, traders will look to exit positions as quickly as possible and will hit any and all bids on the way down until they are out of their positions. Do read: Short Selling isn't for the faint hearted.

Stay prepared. 

Some believe certain stocks are seriously overvalued as there are others who think they are the great companies at value prices.

Let's return to Wallace and his speech to students:

"If you're worried that I plan to present myself here as the wise older fish explaining what water is to you younger fish, please don't be. I am not the wise old fish."

Maybe for many assets, the young fish are right. What the hell is water? Who cares if it took Amazon 20 years to make a profit? Companies in the Goldman Sachs index include Spotify, Shopify and Pinterest. Spotify is redefining how we listen to music, so who’s to say what it will be worth in five years? The young fish swim on, leaping on every word from Elon Musk as if he were The Messiah.

(Goldman Sachs produces an index of listed U.S. tech companies which are not making a profit.)

While the water may be different in some ways, it is still there. We don't know when the market will tumble, but it will. Stock markets fall by 10-20% at least once every few years and every generation sees a 40-50% correction, and this will continue. We don't know if hell freezes over and we can’t put a date on any market event. But instead of fishing around in someone else's pool, we should prepare our own portfolios for the inevitable.

Add a Comment
Please login or register to post a comment.
ninan joseph
Jul 24 2021 01:25 PM
 There are these two young fish swimming along, and they happen to meet an older fish swimming the other way who nods at them and says, ‘Morning, boys, how's the water?’

And the two young fish swim on for a bit and then eventually one of them looks over at the other and goes, ‘What the hell is water?’

The best I have read in a long long time.

Source: https://www.morningstar.in/posts/64134/hell-water-intrinsic-value.aspx
Mutual Fund Tools
Ask Morningstar