Hedge fund billionaire David Einhorn is struggling to make sense of the stock market. In his latest investor letter, the founder of Greenlight Capital raised an interesting question about valuation.
“Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value,” Einhorn wrote in a letter to investors dated October 24. “What if equity value has nothing to do with current or future profits and instead is derived from a company’s ability to be disruptive, to provide social change, or to advance new beneficial technologies, even when doing so results in current and future economic loss?”
Einhorn, who identifies as a value investor, said the market “remains very challenging” for folks like himself as growth stocks with speculative earnings prospects outperform value stocks.
“The persistence of this dynamic leads to questions regarding whether value investing is a viable strategy,” he wrote. “The knee-jerk instinct is to respond that when a proven strategy is so exceedingly out of favor that its viability is questioned, the cycle must be about to turn around. Unfortunately, we lack such clarity. After years of running into the wind, we are left with no sense stronger than, ‘it will turn when it turns.’”
It’s tough being a value investor these days
Greenlight Capital returned 6.2% in the third quarter, bringing the fund’s year-to-date returns through September 30 to 3.3%. Meanwhile, the S&P 500 (^GSPC) rose 4.5% during the period, bringing its year-to-date return to 14.2%.
Value investors like Warren Buffett and finance academics would argue that a company’s true intrinsic value can be derived by discounting its projected future profits. Of course, it’s almost impossible to accurately forecast a company’s future profits. Furthermore, it’s widely accepted that a company’s market price in the short-run is affected by other factors including investor emotions.
One of the most widely-reported signs that the market as a whole is expensive is the cyclically-adjusted price-earnings ratio (CAPE), a measure of stock market value popularized by Nobel prize-winning economist Robert Shiller. CAPE is calculated by taking the S&P 500 (^GSPC) and dividing it by the average of 10 years worth of earnings. It has a long-term average of just over 16. Currently, CAPE is just above 31, which some view as trouble. The only other times CAPE climbed like this was before the market crash of 1929 and the bursting of the tech bubble in the early 2000s.
Einhorn explained that his investment strategy “relies on the assumption that the equity value of a company equals the market’s best assessment of the current and future profits discounted at the company’s cost of capital.” The fund should outperform when it finds opportunities where “the market has misestimated current or future profitability or miscalculated the cost of capital by over- or underestimating the risks.”