The exceptional rally in global stock markets continued last year. The gain of 30 per cent in the MSCI World Index continues the remarkably positive trend broadly in place since the post-financial crisis trough in March 2009. This trend is most pronounced in the US where the widely followed S&P 500 index is enjoying its longest bull-run in history:
S&P 500 index: The longest bull market without a 20% drawdown
More pointedly, the stunning performance of the so-called fangs (Facebook, Amazon, Apple, Netflix and Google) is arguably the key stock story of the past decade.
While it’s natural that such a long positive cycle should raise questions about longevity, no cycle should necessarily ‘die of old age’. On the contrary, the likely mix this year and beyond of moderate, but positive, economic growth combined with continuing policy support, remains a propitious environment for stocks. But before nonchalantly jumping or staying on the trend, some thoughts from nature and the academy are worth pondering.
Small rodents & asset valuation
The lemming is a small rodent usually found in the Arctic Circle. For reasons which have yet to be fully explained, when a lemming at the front of a lemming herd plunges to their death off an Arctic cliff-side, their fellow lemmings dutifully follow to their doom.
Unfortunately, as a powerful explanatory image for human behaviour in many domains, this peculiar pattern of lemming behaviour is all too apt.
Aswath Damodaran is a Professor of Finance at the Stern School of Business at New York University and has been teaching a class in asset valuation there since 1986. In addition to teaching, he has published widely on the subject. His best-known publication is probably his contribution to the popular ‘little book’ series: The Little Book of Valuation, first published in 2011.
Damodaran uses the peculiar pattern of lemming behaviour at the cliff-side to usefully categorise approaches to investing. More particularly, he uses it to rationalise his decision to only make investment decisions based on asset valuation.
To Damodaran, all investors can be categorised as belonging to one of three types of lemming:
- Proud lemmings: Momentum investors who proudly proclaim their unquestioning devotion to following the lead of others. Their approach is simply to buy what everybody else is buying and sell what everybody else is selling, convinced that what has been working will continue working, and that they will continue to profit accordingly. For Damodaran, while this may prove to be the case for a period, such an unquestioning approach inevitably leads such lemmings to follow their leader over the cliff-side to their investment doom.
- Yogi Bear lemmings: Momentum investors of what Damodaran calls the Yogi Bear School. Yogi Bear is a cartoon character from the 1970s whose famous catch-phrase was “smarter than the average bear”. Investors of this school believe that they can follow the herd right up to the cliff-side, i.e. benefitting from the profit of being on the right side of momentum, while being clever enough to pull back just in time to avoid the fall – lemmings who are “smarter than the average lemming”. Doubting the ability of any investor to be consistently smart enough to know where the cliff-side is before plunging to their doom, Damodaran is as scathing about this approach as he is about that of the Proud lemmings.
- Lemmings with life-vests: Investors who calculate a credible intrinsic value for any asset before they buy it. While this gives no guarantee that the investor won’t still plunge lemming-like over the cliff-side, the calculation of a credible intrinsic value lessens this likelihood. Arguably more importantly, in the event of getting wet, it acts like a life-vest to give this lemming a much greater chance of survival. To survive and succeed as an investor, Damodaran recommends being a lemming with a life-vest.
By first defining intrinsic value as “the magnitude of the expected cash-flows of the asset over its lifetime and the uncertainty about receiving those cash-flows,” he then goes on to outline a comprehensive process for calculating a credible intrinsic value for any asset. This calculation is the life-vest. Without it, our chances of plunging and drowning are dangerously greater.
Facing into a new year and beyond, before making any investment decision, try to recall the three types of lemming. In the context of the extraordinary stock-market performance of recent years, not doing so could yet prove very costly. Failing that, at least try to recall his warning that the seven most dangerous words in investing are: “They must know something that I don’t!”