“Fair Value”: The GMO Perspective

The big question on many investors’ minds lately has been whether the recent market plunge has caused stocks to be undervalued — and, if so, how much more undervalued they might become. One obvious question involved in that debate: What goes into figuring the fair value of the market?

In a white paper recently posted on the website of GMO — Jeremy Grantham’s firm — Ben Inker takes a shot at answering that question, and provides some very interesting insights. (To access the site, you need only to provide your email address and create a password.)

“Stocks,” writes Inker, the firm’s director of asset allocation, “are worth the present value of the future cash flows they will deliver to their owners. Since stocks do not have an expiration date and dividends grow over time, the duration of stocks is extremely long.” Inker estimates that half of the market’s value comes from cash flows that will occur more than 25 years out into the future — which means that economic ups and downs in the next year, five years, or even ten years have less of an impact on the market’s intrinsic value than you might think.

Of course, many fear that the current economic malaise is “different” — that is, it’s not part of a cycle, but instead of a game-changing set of circumstances. Inker disagrees. “The productive capacity of the economy comes from the skills and size of the workforce and the country’s accumulated intellectual and physical capital,” he writes. “If GDP were to fall by 5%, it would not be because our ability to produce goods and services had fallen by 5%, but beause aggregate demand for those goods and services had fallen. When the demand returns, the economy will be able to ramp up production quite quickly.” Inker provides some long-term charts showing U.S. GDP as evidence that the economic output reverts to a mean. He also provides some charts showing how GDP in Germany eventually reverted to a mean even after the devastation of World War II. That devastation eventually left the German and Japanese economies “without a noticeable trace”, as GDP recovered.

Dividends — which he says drive the intrinsic value of the market — have also been quite stable over the long term, notes Inker. “If the Great Depression and two world wars failed to materially change the long run path of GDP or dividends,” he says, “then it seems that the safest assumption is that the credit crisis will not, either.”

The question today is thus not how much equities have fallen in real underlying value, Inker says. “We never thought equities had gained in intrinsic value in the credit bubble, and we think there will be little long-term impairment from the credit bust,” he says. The question, instead, is thus how much investors will overreact to the current crisis, “and how undervalued the equity markets may get as a result.” Valuations have been lower in past crises, he says, and GMO is trying to figure out why they got that low to determine how low they might get this go-round.

The bottom line: “Given our assumptions, fair value for the S&P 500 is around 900,” Inker says. “Long-term investors in stocks should therefore do well if they invest at current levels. An investor who correctly guesses that the market will bottom at 600 and waits until then to invest will do even better. But that investor is taking the risk that investors overreact less to this crisis than they have in previous crises and, in waiting for the perfect entry point, may miss the best opportunity to buy equities in over 20 years.”

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