Relative valuation is the notion of comparing the price of an asset to the market value of similar assets, and it's wrong according to Walter Schloss, one of the superinvestors of value investing.
Schloss is one of value's most renowned investors. He worked with Benjamin Graham and went on to achieve returns of 21% per year for 47 years for partners when managing his own investment firm by investing in deep value equities.
Here's what Schloss had to say about relative valuation in 1974:
"I note in your Editor's Comment in your September/October issue, you quote Sidney Cottle as saying:
'Security analysis is the discipline of comparative selection. Since stocks are only under or overpriced with respect to each other, the process of comparison is going to identify over- and under-priced stocks with roughly the same frequency in good markets and bad.'
I'm not sure what you have said above is what Mr. Cottle means but I must say as a security analyst I take exception to this point of view.
I believe stocks should be evaluated based on their intrinsic worth, NOT on whether they are over- or under-priced in relationship with each other. For example, at the top of a bull market, one can find stocks that may be cheaper than others, but they both may be selling much above their intrinsic worth. If one were to recommend the purchase of Company A because it was COMPARATIVELY cheaper than Company B, he may find that he will sustain a tremendous loss.
On the other hand, if a stock sells at say, one-third of its intrinsic value based on sound security analysis, one can buy it irrespective of whether other stocks are over- or under-priced.
Stocks are NOT over-priced or under-priced compared to other companies but compared to themselves. The key to the purchase of an undervalued stock is its price compared to its intrinsic worth."
The problem with relative value is that it does not take into account each individual situation. If a company is trading at only five times forward earnings, in a truly efficient market, it is trading at this level because it deserves to, even if it may be a discount of 50% the rest of the sector.
Value on assets, not earnings
Valuing each company on its own merits alone was one of Schloss' fundamental skills, and when doing so, he didn't want to use earnings. Instead, the first place he looked for value was on the balance sheet -- among the company's assets. He explained why he favored this approach in a 1989 issue of Outstanding Invest Digest:
"Assets seem to change less than earnings. You could argue that assets are not always worth what they’re carried for. [Ben] Graham made an argument at one point that inventory was a plus, not a minus. In an inflationary period, having a big inventory might be very helpful. While in a deflationary period, a big inventory would not necessarily be good....If you have two companies – one with a plant that’s 40 years old, another with a new plant – both are shown on the books but the new plant may be much more profitable than the old one. But the company with the old one doesn’t have to depreciate it. So he may be overstating his earnings a little bit by having low depreciation.
...Ben made the point in one of his articles that if U.S. Steel wrote down their plants to a dollar, they would show very large earnings because they would not have to depreciate them anymore. Would that be proper? Of course, he didn’t think it would be. But that means a company could really increase its reported earnings. And that’s only one of the reasons why Edwin and I aren’t wild about earnings. They can be manipulated – legally. If people are just looking at earnings, they may get a distorted view."
In other words, Schloss wanted to eliminate as much as possible the risk that he might mis-estimate a company's intrinsic worth.
If you calculate the intrinsic value based on positively adjusted earnings figures, you could end up with an optimistic estimate of intrinsic value eliminating any margin safety. This coupled with a relative valuation gives you nothing more than a tower of cards.
Disclosure: The author owns no share mentioned.
