The May/June edition of the CFA Institute’s Financial Analysts Journal features the article, “Should Good Stocks Have High Prices or High Returns?” Not withstanding the ambiguity of the term “good,” the logical answer to the question is that the fair price for any investment is the future stream of cash flows the investment will provide, discounted at a rate that incorporates the expected natural rate of interest over that time period and a risk-premium to account for the possibility that the cash flows don’t occur (or the timing changes, etc.).
The article goes on to define “good” using several metrics. One metric is the amount of leverage a firm has – low is good, high is bad. The higher the leverage, the greater the possibility the firm goes bankrupt and the future cash flows don’t occur. So, based on this definition of “good”, a “good” stock should have a higher price and a lower return. Think about it this way: A given firm’s equity should have a higher return than the same firm’s debt because (among other reasons) the debt gets paid first and therefore has a higher probability of being paid. All else being equal, a firm with lower leverage has a smaller chance of bankruptcy than a firm with higher leverage and thus a greater probability of paying the expected cash flows. Thus, the risk premium should be lower and the expected return lower for a firm with less leverage. The article highlights empirical evidence that bears this out.
Here is where it gets scary: When asked about this issue, professional financial advisers gave diametrically opposed answers depending on how the question was asked. When asked if they required a higher rate of return for a stock with higher leverage, 86.2% of advisers said yes. When asked if they expected a higher rate of return for a stock with higher leverage, only 12.5% of advisers said yes. Advisers are clearly prone to many of the same behavioral biases that affect laymen.
Two important conclusions can be drawn from the article:
- Aspects of the stock market are NOT efficient. When professionals answer the same question regarding valuation with opposite answers depending on how the question is framed, mis-pricings will abound.
- When seeking investment advice: caveat emptor. As the article states, “avoiding investment mistakes is one of the leading reasons for using the services of financial advisers. The value added from the advice, however, is compromised if the advisers are subject to the same biases as the individual investors.”