What Austrians can teach value investors
Austrian economics can explain the theory behind value investing rules; like why price gravitates towards value, or why volatility does not define risk
For decades now, value investors have believed the price of a security could deviate considerably from its intrinsic value. This is much in contrast to the practitioners of mainstream finance who assume, as a matter of fact, that prices accurately reflect underlying value at all times. But the theory behind price-value discrepancy has remained unexplained even by value investors, all while many assuming the rules of value investing to be a fact have gone onto make billions.
In March 1955, when asked, “What causes a cheap stock to find its value?” the father of value investing Benjamin Graham had this to say, “That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. (But) we know from experience that eventually the market catches up with value.”
In the Austrian view, the market economy is in a perpetual state of disequilibrium, that is, factor prices do not strictly reflect their intrinsic or discounted marginal value. This makes the real world much different from an evenly rotating economy (ERE) that Austrian economist Ludwig von Mises described as “a fictitious system in which the market prices of all goods and services coincide with the final prices... the sum of the prices of all complementary factors needed for production precisely equals the price of the product.” The ERE is much like mainstream static equilibrium models that assume prices to perfectly reflect value.
In the real world, such perfect equilibrium is almost never reached for two reasons. First, in the face of constant change in consumer preference, the market data to which entrepreneurs have to perpetually adjust production fluctuate. Second, since the production process caters to future demand, which always remains an uncertain prospect, entrepreneurial errors are likely. These factors allow for factor prices to deviate, sometimes widely, from their intrinsic value (or discounted marginal value) for varying periods of time.
Entrepreneurs correcting such imperfection by allocating capital in the right lines of production, causing factor prices to move towards equilibrium in the process, earn profits. While those who further aggravate disequilibrium by allocating capital in the wrong lines of production, thus pricing factors above their intrinsic value, incur losses. In other words, profits and losses are arrived through time arbitrage, wherein an entrepreneur buys factors in the present at a price below or above intrinsic value to sell at a higher or lower price in the future.
In general, with time competitors tend to spot the presence of under-priced factors and bid up their prices in search for profits. It is, thus, only in spotting market imperfections before competitors do that an entrepreneur gets to purchase under-priced factors, and wait till others bid up the price in the future to earn profits on the investment. Notably, also, it is competitors’ search for profits that pushes the price of factors towards intrinsic value—thus providing entrepreneurs with the confidence to invest in under-priced factors and wait patiently.
As Mises said in explaining the nature of profits, “The only source from which an entrepreneur’s profits stem is his ability to anticipate better than other people the future demand of the consumers. If everybody is correct in anticipating the future state of the market of a certain commodity, its price and the prices of the complementary factors of production concerned would already today be adjusted to this future state. Neither profit nor loss can emerge for those embarking upon this line of business.”
All this holds no less true with regards to securities, which in a state of perfect equilibrium would be priced at their intrinsic value (that is, discounted value of future cash flow). However, owing to the constant flux in market data and forecasting errors, it is plausible that the price of a security could be lower than its intrinsic value, giving the opportunity for investors to profit from under-priced securities. Note that such purchase of securities at a bargain would be no different from buying land or any other factor at a deep discount to its intrinsic value—in both cases, profits are earned through time arbitrage.
The value investor in particular buys securities at a price below intrinsic value—owing to better skills of speculation—waits through time, and sells at a higher price later when other entrepreneurs bid up its price. He spots imperfection in the securities market and takes advantage of it to reap benefit as the market moves further towards equilibrium when competitors spot the imperfection later. Here too, it is in the tendency of market players to search for profits that the value investor trusts while playing the contrarian game of purchasing out-of-favour securities.
It is an understanding of the economic foundations of value investing principles that can help investors engage in time arbitrage with the temperament required to wait it out. If the intrinsic value of a particular stock—based on the raw fundamentals of a company—is stable or growing, the volatility in its price movements should not matter as long as the price paid is below intrinsic value (thus assuring a ‘margin of safety’). Given enough time, the market will tend towards intrinsic value and profits can be had. As legendary value investor Philip Carret mentioned, “If you own a good stock, sit on it.”
Also, it is the price an investor pays for a security that determines his returns, not risk—an approach much different from mainstream belief that risk can be defined or even measured with Greek letters. If a security with uncertain future cash flow can be bought at a sufficient discount to value, it may still turn out to be less risky than otherwise believed. In all, it is in understanding the economic fundamentals of the price-value discrepancy and the forces that cause the gravitation of price towards value that Austrian economics can contribute to sound investment theory.
Natural Order runs every Monday, with a libertarian take on the world of economics and finance.
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First Published:10 Jun 2014, 12:55 PM IST
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