Jim Surowiecki on How Stocks Work - 5/Nov/2008

After I wondered
whether US stock market investors should think about learning from
Japan, Jim Surowiecki responded with a carefully-argued blog entry
about Japanese stocks entitled "There's a Reason It's Cheap", concentrating on the fact that Japanese companies generally have very low returns on equity.

I'm very interested in the art and science of stock-market
valuation: while I think I have a very good grip on how to value a
bond, I find myself much more at sea when it comes to stocks. But Jim
thinks there's not so much of a difference between the two. When I
asked him a few questions about his blog entry and stock valuation, he
emailed back:

Let me just say one thing by way of introduction,
which is that I think the distinction you're implicitly making between
valuing stocks and valuing bonds is really a false distinction. Valuing
stocks is arguably more challenging than valuing bonds, because the
range of variables is wider, but stocks and bonds both represent claims
on the cash flows generated by a company, so in both cases valuing them
accurately entails valuing those cash flows. That's why my discussion
of the Nikkei focused on the underlying performance of Japanese
companies: ultimately, stock prices reflect the cash flows companies
can (or, in Japan's case, can't) generate.

Jim then responded to my questions one by one. The answers were very
helpful for me; I'm still not entirely there, but I'm closer than I
was. The whole concept of "equity" is still difficult, for me: for
instance, Andrew Ross Sorkin
today has very nice things to say about an executive-compensation plan
which on the one hand is based on accounting performance rather than
stock performance, but which on the other hand penalizes "bankers who
destroy shareholder value". Isn't the ultimate gauge of shareholder
value the share price? Or was it justifiable for, say, Bob Nardelli
to earn lots of money based on Home Depot's accounting performance and
rising return on equity, even as the company's stock price went nowhere?

In any case, here are my questions, and Jim's answers.

Felix Salmon: What's the relationship, in theory,
between a company's return on equity, on the one hand, and its stock
price, on the other? Does a high return on equity mean a rising stock
price, or is it a rising return on equity which means a
rising stock price? Or, to put it another way: if one company has an
ROE which is (expected to be) flat at 4%, and another company has an
ROE which is (expected to be) flat at 14%, would you expect the latter
to rise more than the former, or indeed either of them to rise at all?

Jim Surowiecki: Your first question, unfortunately,
can't really be answered in the abstract. It's perfectly possible for a
business with high returns on capital to still be overvalued - that is,
for its stock price to overestimate the cash flows it will generate
over time. In that case, the fact that a company is generating high
returns on capital won't translate into an increase in its stock price.
Microsoft's average return on invested capital, for instance, is
consistently good - above 25% -- but its stock is just about where it was a decade ago.

This speaks to your second question, which is really about
expectations. If the market is accurately forecasting the returns on
capital of the low-ROIC company and the high-ROIC company, you wouldn't
expect the latter's stock price to dramatically outperform the former.
But assuming both are fairly valued, the high-ROIC company will have a
much higher valuation, meaning it will generate more income for
shareholders going forward (in the form of dividends, buybacks, etc.)

That's why, all things being equal, you want to own shares of
companies that generate high returns on capital rather than those of
companies that don't. This is, in a way, self-evident. If you put money
into a company, you want it to use that money to generate high returns,
higher than you could get elsewhere. That's what companies that have
high returns on capital do: Microsoft earns an additional twenty-five
cents for every dollar it invests. By contrast, companies with low
returns on capital create less value, and companies that earn returns
that are lower than their cost of capital (as was true of Japanese
companies between 1990 and the early part of this century) actually
destroy value for their shareholders.

FS: What's the relationship between stock price,
ROE, and risk-free rate of return? Would one expect ROEs in a country
with a zero risk-free rate to be lower than ROEs in a country with a
higher risk-free rate? How does that feed in to stock prices, if at all?

JS: You would expect returns on invested capital to
be lower in countries with lower risk-free rates (like Japan). Two
reasons suggest themselves for this: first, the low risk-free rate may
be indicative of lower growth prospects for the economy as a whole. But
also, when the risk-free rate is low, the hurdle rate for corporate
investments is also lower (because investors' expectations of what
counts as a reasonable return are also lower.) That may make companies
more likely to invest in low-return projects. Both factors have
something to do with why Japanese firms have underperformed over the
last twenty years (and in particular in that 1990-2002 stretch). But I
think the most important factors explaining the low ROIC of Japanese
firms were their indifference to shareholder value and their
willingness to invest in value-destroying projects.

FS: How can a company with a positive ROE destroy economic value for shareholders?

JS: The key to understanding how a company with a
positive ROE can nonetheless destroy economic value is simply
recognizing that equity is not free. It has a cost, just like debt
does, a cost that reflects the return that investors demand as
compensation for the risks and opportunity costs that owning equities
entail. We can debate how to calculate that cost of equity (risk-free
rate + market risk premium is a simple solution). But the basic
principle is, as I said above, that a company is only creating economic
value for its shareholders if it's earning more than its cost of
capital. Again, this is intuitive: if you were the part owner of a
company that, on a risk-adjusted basis, was earning less than the yield
you could get on a 30-year T-bill, you probably wouldn't keep your
money in that company, because you would effectively be losing money
with every day that passed. Shareholders feel the same way, so the
share prices of companies that earn less than their cost of capital are
unlikely to rise over time. According to a study by the Japanese
government, Japanese companies' return on capital was below their cost
of capital for roughly the entire decade of the 1990s through 2002. If
you want to know why Japanese stock prices fell precipitously during
that period, that's the biggest reason why: the companies weren't
creating any value for shareholders. And what made it worse was that,
as a result of the bubble, expectations were already inordinately high.

One thing I should say, though: Japanese companies have
significantly improved their performance in the past five years, and
there's a strong case to be made that, as in the U.S., the recent
sell-off of the Nikkei has been massively overdone. In fact, if you
think that the transformation of Japanese firms in recent years will be
long-lasting (I'm agnostic on the question), then the Nikkei looks very
undervalued right now - or at least it did before it rose something
like 15% in the last week and a half.