Monday, May 28, 2012

There are two types of value: intrinsic value and speculative value.

Thanks Rob, thoughtful and provoking when thinking about investing. Aivars Lode


The best definition of intrinsic value is cash flow.  Pretty simple. Easy to
calculate and mostly what "fixed income" (e.g. debt, bond) markets are all

The other type of value is speculative value sometimes called equity. The
most obvious manifestation of speculative value is the stock market, where
"equities" are issued, then bought and sold, over and over.

Speculative value (equity) is basically the concept of buying and selling a
title to some "asset". (The term asset is used loosely in the context of
equities.) The buyer of the title to the asset believes that in the future
there will be some event or change of perception that will allow them sell
it for more money than what they paid when they bought it. The thing backing
up the equity could be completely vacuous like an eyeball looking at a
webpage (worth speculatively millions), or a physical thing like a building,
which may have a replacement cost of say $10 million but could be be worth
zero or even have negative "equity" (you have to pay to demolish it.)

In theory, over the long term, the events that create equity value are an
increase in dividends (more on dividends in a minute) or an improvement in
the balance sheet (retained earnings, accumulation of sellable assets,
issuance of notes payable, etc.). But in the real world equities are valued
on pure perception (speculation). Actually, the second or third derivative
of perception (i.e. "I perceive now is the time to buy equities, because I
perceive that others who do not perceive now is a good time to buy equities
will down the road perceive that others will perceive that they should buy
equities in larger numbers... "ad infinitum) In other words the equity value
of an equity is derived from the belief that someone in the future will
believe that down the road further, someone will else will pay more. It is
really that simple. The real trick to equity pricing is to try to figure out
what people believe and what is likely to change their minds - 100%
psychology and like ALL FORMS of psychology, no science whatsoever - just

I am not saying people do not love to toss around numbers in equity markets.
Is there growth in earnings? Is there growth in revenue? Is this "expected"
or not (e.g. beat the official estimates and/or "whisper numbers")? Does
this company's "equity" have the same price to earnings, or price to
revenue, ratio as a competitor of the same size, balance sheet, same growth,
same margin, etc. If not, can these discrepancies be accounted for? Does the
company pay a dividend? Is it increasing?  etc. etc. But these are just
mental masturbations The only thing that matters is playing the perception
game. This is why stocks frequently go down after a stunningly good quarter.

Equity markets move from a numeric analysis to a perception analysis in the
blink of an eye,  That is not to say the numbers do not matter to some
extent, but numbers only matter to the degree they change perception.
So-called good numbers do not always lead to a good change in perception
(again, not the first derivative). There is a ton of evidence in equity
markets that demonstrates these phenomenon, but my favorite is looking at
the stock price movements when a company "misses the quarter" could go up -
could go down - could stay the same - depending on what the expectations are
and how they changed. Hence the source of, "I buy on dips."

One other note before moving on to intrinsic value is an analysis of
dividends. For equities that pay dividends, a partial intrinsic value can be
found in the ratio of dividend amount to speculative price. But be careful,
paying a dividend actually reduces the theoretical equity value of a company
(reduces cash).  Dividend values of equities (unless the dividend is
abnormally high compared to a corporate bond) is typically a minor kicker to
the stock. Increasing dividends has a de minimis impact on equity value as
compared to speculative values (i.e. the attempt to buy low and sell high).
Sometimes an increase in dividends will move a stock, but not because of the
intrinsic value, but because it is perceived to be a signal that will be
perceived by non-believers that the company has more "good news" which will
further change perceptions in the future. I am quite serious.

Bottom line: equities are valued on speculation.

Intrinisic value is a whole 'nother kettle of fish.

Intrinsic value is almost all mathematics. Intrinsic value is simply the
cash flow generated by an "asset". The formula can be quite complex taking
into account the net present value of the cash flow and the risk the that
cash flow is not secure and steady (predictable).  But no cash flow - no
intrinsic value. Period. For investors to balance a portfolio the future
will be products that have a relatively high cash flow (yield) with
relatively low risk.  Funds that do not take equity, but accumulate "bonds"
by concentrating on securing intrinsic value claims (cash flow) via secured
structures will provide stability in an investment portfolio.  Investments
are technically more like Convertible bonds than straight debt, because of
covenants that give ultimate control of operations without a traditional
default event. Funds like this are the future unique, modern,
differentiated, not a PE, not a VC, not a traditional bank, not a
hedge-fund, etc.

There is some confusion around intrinsic value "assets" like corporate and
government bonds because, in addition to yield, they also have a "price" -
i.e. some bonds do indeed trade. Bond trading is the result of a pseudo
perceived speculative value around relative yield and relative risk.  The
factor that causes speculative changes in the price of bonds is the global
shifts in interest rate expectations (speculation) for the same level of
risk. If you own a ten year U.S. Treasury eight years away from maturity
with an intrinsic value (yield) of 2% and the market begins to speculate
that the government will next issue ten-years for 2.2%, then the "price" of
your bond will go down. Notice that the price of the bond does not change
when the new higher rate bonds are sold if the speculation on future rates
is confirmed and does not create new speculation. But this assumes you would
sell it before maturity (now). If you own a ten-year bond with one year left
to maturity the speculative impact of a change in global interest rates is
tiny. If your intent is to hold to maturity the "price" of your bond beyond
intrinsic value is irrelevant.

Consequently, intrinsic value assets that do not trade do not have
speculative value. Intrinsic value assets that do not have a maturity are
probably impossible to speculatively price objectively, anyway.  The only
objective value is the current cash flow.

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