Water firms still use diving rods; what magic should investors believe in?

With Santa Claus steeling himself to fill the stockings of more than two billion children in a matter of hours last Sunday night (NB: figures not adjusted for final naughty/nice calculations), Christmas is traditionally a time of magic or, perhaps, the willing suspension of disbelief.

However, we do wonder if there is enough of either quality – even now – to sustain the valuations of certain growth stocks at their current elevated levels.

Certainly some businesses are not averse to a spot of magic, if this blog by biologist Sally Le Page is anything to go by.

She was astonished to discover 10 of the UK’s 12 water companies cheerfully admit they still use ‘dowsing’ or ‘divining’ rods to work out where existing mains pipes are located underground. In the Middle Ages, people believed the rods would magically cross when they passed over water.

Apparently some still do.

Business magic

A belief in business-oriented magic is more generally evident in the way the market values companies.

In theory, the valuation of a company should be based on considerations such as the assets it owns and the profits it has made in the past.

In practice, however, part of a company’s valuation is often attributed to more otherworldly considerations, such as future growth and other matters we cannot see or even know.

What is more, being magical, this portion does not remain constant but expands and contracts depending on investors’ feelings about the market outlook.

In recent years, this element of the valuation of a variety of more growth-type businesses has been bid up significantly as people have fallen under the spell of the prospect of future growth while ignoring those aspects, such as underlying assets and fundamental earnings, on which value investors place greater weight.

On this point, the father of value investing Ben Graham himself wrote:

“Obviously the stock market is quite irrational in thus varying its valuation of a company proportionately with the temporary changes in reported profits.

"A private business might easily earn twice as much in a boom year as in poor times, but its owner would never think of correspondingly marking up or down the value of his capital investment.”

For his part, highly regarded value investor James Montier has observed:

“Perhaps the most persistent mistake I encounter is investors overpaying for the hope of growth. It always seems seductive to rotate to something proffering the hope of growth but, all too often, we forget the lags that typify turning points.

"This is made all the more dangerous when the markets concerned are trading on massively elevated valuation multiples.”

Our determination to remain grounded in facts and figures rather than be swept up in magic and emotion should not, of course, be seen as denying the existence of Father Christmas.

But as his magical journey in 2017 has come to an end perhaps it's time investors in some highly valued growth stocks reassess and acknowledge their current hopes are in danger of having a very unmagical ending.

  • Ian Kelly is an author on The Value Perspective, a blog about value investing. It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.

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