Consider the following fictitious passage from a typical sell-side analyst report;
“Company XYZ had a terrific quarter by all accounts. Multiple divisions are firing on all cylinders, and, therefore are raising estimates...... As the stock is currently trading at 24 times this year’s numbers and 20 times next years we continue to believe it to be undervalued relative to its peer group. Therefore, we strongly recommend purchase of the shares with a $40 price target.”
While this exert was not an actual research note, I see pieces like it almost every day. If you don’t believe me check out the daily research notes Wall Street firms regularly publish. When I first entered the investment business, this logic always struck me as very odd. I thought - simply because it’s cheaper than its competitors doesn’t mean it’s cheap on an absolute basis. What if the entire group is overvalued? This thought process still doesn’t make sense to me and I’m curious as to why this isn’t an obvious oversight.
In my last piece, I discussed some of the short comings for the sell-side analysts. The ‘cheap relative to peers’ theory is definitely a major flaw in thinking. It really gets down to thinking about things on an absolute basis. The lesser of two evils is still not a profitable choice. We are all familiar with the Buffet methodology that says swing only at the fat pitches. We have the advantage of being able to let many pitches go by without taking any swing.
Relative versus absolute seems to be an ongoing debate in the financial world. In fact, some of us govern our entire world by the concept of relativism. For example, “I may be wealthy, but I am less wealth than my neighbor so I feel poor.” Amazingly, people actually think this way. In yet another example, absolute versus relative is very prevalent when it comes to performance measurement. Many large mutual fund rating services will give a certain fund high marks simply because it outperformed its peer group (so what the fund was down 30% on an absolute basis!)
The choice to compare and contrast can have value in the world of investing, but at the end of the day one is left the absolute only. One either owns a particular stock, bond, real estate, etc. or one doesn’t. It is of absolutely (pun intended) no value to say – “ my investment decreased in value less relative to other investments”.
