Fair Value? Really?

Brit Ryle

Posted April 11, 2023

Happy belated Easter!

I hope everybody had a nice and relaxing holiday weekend. My cousin, his wife and daughter stopped by for a night on their way from Charleston to Disneyland. Hadn’t seen them in almost two years so that was fantastic…

Of course, even with a holiday and little family get-together, I still spent some time doing what I do. And I’ll tell ya – I have a real problem with the Second-Quarter U.S. Stock Market Outlook that ratings firm Morningstar released on March 31.

And my problem is that Morningstar is declaring that the “stock market” is currently trading at a 12% discount from what it calls “fair-value.” 

Believe it or not, Morningstar says that it knows exactly what price 700 stocks should trade at to be considered fair value. And if that’s not enough, Morningstar then adds all those 700 stocks up, calls it “the stock market” and declares whether it’s undervalued or not…

There’s just so much wrong with this kind of analysis, I barely even know where to begin…

I guess I could start with the whole concept of “fair value”  

I expect that if you’ve bought more than two or three stocks in your life, you’ve probably given up on the notion that there’s anything “fair” about stock prices – especially in the short- to medium-term.  

Was it “fair” that shares of Bank of America traded down to $3.15 a share in March of 2009? Is it “fair” that despite growing annual revenue from $18 billion to over $51 billion in 20 years, you’d still be underwater if you bought Cisco stock in 2000? 

Of course not. 

As a company, Tesla (NASDAQ: TSLA) has executed almost flawlessly for the last several years. And yet the stock price has been cut in half over the last 18 months. 

Of course, one could certainly argue that, at $380, shares of Tesla were trading way above what might be called “fair value.” And in hindsight, Tesla shares absolutely were trading at a premium to what might be considered a reasonable price. 

Still, I don’t recall Wall Street analysts lining up to say it might be time to sell Tesla. In fact, there were some analysts – ahem, Cathie Wood of ARK infamy – telling investors to load up. 

How’s that for “fair?”

About that Market…

Another thing that really bugs me about Morningstar’s determination that the “stock market” is 12% undervalued is the sample size: 700 stocks.

There are ~5,300 publicly traded stocks out there. And Morningstar wants to declare that the entire stock market is undervalued based on its concept of what’s “fair value” for 700 stocks?

Seems like a reach…

With 5,300 stocks out there, it’s a pretty good bet that a pretty solid percentage are complete crap and should be completely off-limits for individual investors. And I will be so bold as to say that even within Morningstar’s cozy little neighborhood of 700 stocks, there will be more than a handful of crap. 

And I can illustrate this point pretty simply with a table I grabbed from the good folks at FactSet (John Butters does great work on S&P 500 corporate earnings in the “Insights” section at FactSet)…

fair value investing

This table shows the 10 stocks on the S&P 500 that have the biggest difference between current price and analyst target price. 

Now, obviously, you see a stock trading at $12.50 a share that analysts say should trade up to $135 a share, well, hey, might be able to make some loot on that one, right? 

Except it’s a regional bank. And regional banks are…kinda out of favor right now. And given the amount of depositor money that has gushed from regional banks into the majors and it’s really hard to imagine that “fair value” for these stocks is anywhere close to what analyst price targets are. 

You’ll notice that 6 of the stocks on this table are regional banks. A seventh, Lincoln National, is an insurance company that will have the same kind of impaired assets on its balance sheet that brought down the regional bank sector. 

Given the very well known problems at regional banks, why haven’t analysts revised their price targets for these stocks? 

Seems pretty irresponsible to leave First Republic Bank with a $135 price target when the stock is trading for $12.50 (though in fairness, First Republic shares have rallied up to $13.85, so who knows, maybe there’s another 100 bucks of upside coming?)

The second problem here is that First Republic Bank is still a member of the S&P 500, as are a lot of regional banks. Analysts have been slow to adjust their ratings and earnings estimates for this entire sector, which means that S&P 500 earnings estimates and valuation calculations that are more than a week old are not accurate…

For example, 30 days ago, right around the time that Silicon Investment Bank was failing and regional banks were getting whacked, analysts were forecasting that First Republic Bank would earn $6.07 a share for fiscal 2023. 7 days ago, that number had been cut to $3.22 a share in earnings. Today, analysts estimate that First Republic Bank will earn $0.94 a share for fiscal 2023. 

So tell me again Morningstar, how your determination that the “stock market” was 12% undervalued on March 23 is looking now, just a couple weeks later? 

A Great Company at a Good Price

Ok so maybe I’m being a little hard on Morningstar. My point is simply that individual investors should not take Wall Street analysis at face value. Yes, it’s always a good idea to have an idea of what analysts are projecting. But it’s critical to also have an idea of how they may be wrong…

And this is true for both bull markets and bear markets. Because Wall Street analysts will always be a little slow to incorporate the most recent developments into their models, and that’s true for both bullish developments and bearish developments. 

This is why individual investors are much better served following a simple observation from good ol Warren Buffett, when he said he’d rather buy a great company at a good price.

From an investment perspective, great companies all have a few things in common. 

  1. Great companies offer services or products that are popular and in demand 
  2. Even with just moderate innovation, great companies can expand their product/services offerings
  3. Management teams at great companies streamline operations and lower costs, thereby increasing earnings
  4. Great companies can raise prices without losing sales

There’s a reason why Warren Buffett has something like 40% of his money in Apple (NASDAQ: AAPL). There may not be another company on the planet that better illustrates the 4 characteristics I just laid out…

I got a few others on my mind that may get a write-up here at Pro Trader Today in the near future. I think Spotify (NASDAQ: SPOT) is right on the brink of becoming a great company. Yeti (NASDAQ: YETI) might already be a great company.  

Palo Alto (NASDAQ: PANW) and Advanced Micro Devices (NASDAQ: AMD) definitely make the list. I’d put Starbucks (NASDAQ: SBUX) on the list except I’m concerned by how dependent the company is on its China expansion plans.

With 33% earnings growth coming in its next fiscal year, gotta put Disney (NYSE: DIS) on there. 

I got a few more up my sleeve. But if you got any great company ideas, send them in and we’ll discuss them in future editions of Pro Trader Today – here’s the email brit.ryle@protradertoday.com

That’s it for me today, take care and I’ll talk to you on Wednesday…

Briton Ryle
Chief Investment Strategist
Pro Trader Today
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