Playing To Win
Don’t Let Them Compel You to be Stupid
Averting the Dangers of Overvalued Equity
I was blown away by the reactions to the short discussion of dangers of overvalued equity toward the end of my recent piece on strategy in high-growth industries. Because readers wanted much more, I have decided to write a full Playing to Win/Practitioner Insights (PTW/PI) piece, my 12th in Year II, on Don’t Let Them Compel You to be Stupid: Averting the Dangers of Overvalued Equity. You can find all previous PTW/PI here.
What is a Stock Price?
To understand this tricky issue, it is necessary to start by going back to the fundamentals to ask: what is a stock price, anyway? The important thing to note is that it is a social construction, not a real, tangible thing. A stock price is, at any given point in time, the summary of all the expectations of the participants in the market as to what the company might do in the future. It is most certainly not about the here and now. The median (trailing) PE of S&P 500 since its inception in 1927 is 16.5x, which means, notionally, that you pay, on average, once for the current earnings and 15.5 times that much for what you expect its earnings to be in the uncertain and unknowable future. Said another way, for an average company you pay 6% for the now and 94% for your imagination about what the future for the company may or may not hold.
Given that a stock price is the summary of the expectations of all participants in the market for the stock, the only way for a stock price to rise is for expectations to rise from their current level. Nothing else will do it. Increasing today’s performance may drive expectations up or down depending on the existing expectations. Only by increasing today’s performance by more than what was already expected is the stock price likely to rise.
Despite the speculative nature of stock prices, the dominant view that the market capitalization of a company is the definition of its real value. But in fact, it is as real as the Easter Bunny or the Loch Ness Monster. It can be anything that observers want it to be. All you can ever know about the meaning of a stock price is that as many equity market participants think it should be higher as think it should be lower — otherwise, the price would be at a level other than it is.
The Problem with Expectations
Sometimes, expectations are nicely in line with reality. That is, the expectations amount to an accurate prediction of the future performance of the company. Sometimes, expectations are unduly low, especially when things are bad. These are the troughs of fear and despair that produce undervalued equity of the sort followers of Benjamin Graham and Warren Buffett covet.
But sometimes expectations are crazy on the high side. Remember 2000. It was a new paradigm. Forget that old-fashioned stuff like revenues or profits. It was all about eyeballs or miles of fiber laid. Those were the drivers of expectations. In 2022, it is Telsa at $1 trillion. Tesla is viewed as analogous to a software company like Google or Facebook or Netflix for which the cost of production for an incremental unit for sale is zero. Unfortunately for Telsa, when another customer orders one of its vehicles, it has to phone up its suppliers, spool up production, weld a vehicle together, and transport it physically to that customer. Those costs aren’t even close to zero — though I would argue that the expectations embedded in the stock price assume that they are.
Even when crazy/insane/lunatic expectations send a company’s stock price to a stratospheric level, the management team still faces overwhelming pressure to earn a healthy return on it. For example, Pfizer is a great pharma company with a market capitalization of north of $300 billion. If certain investors look at its clinical trials and come to the belief that Pfizer is closing in on a cure for cancer, they could bid the market capitalization up to (say) $3 trillion. Remember, this is involves buying and selling between independent third parties over which Pfizer has no direct control. And Pfizer receives no additional capital, as the $2.7 trillion that is created accrues to the selling shareholders.
Yet Pfizer would be on the hook to earn an acceptable return for shareholders who bought in at the $3 trillion valuation, not on $300 billion, with not a cent more in capital to use. Management would be harangued at annual meetings for earning $30 billion in profits — a fine return on $300 billion but a terrible 1% return on $3 trillion. And hedge funds would lurk, threatening to unlock value by replacing “incompetent management” and breaking up the “terribly underperforming company.” Any sensible strategy agenda on the part of the CEO and management team goes out the window — because runaway expectations create overvalued equity.
That is when the real craziness sets in. The executive team knows at best it is going to have to put up with continuous haranguing from unhappy purchasers of the stock at the overvalued level, and at worse, activist hedge fund attacks. At this point, the CEO feels intense pressure to take ever more desperate actions to raise expectations further in order to produce a return for the unhappy shareholders. Remember, the expectations are irrationally high already and the only way to increase share price is to raise expectations an even further distance from reality. For example, Pfizer would have to quickly figure how to cure Alzheimer’s or diabetes, in addition to cancer.
Those desperate actions can be perfectly legal — like making unwise acquisitions that pump up growth in the short term. Others are legally suspect — like using aggressive accounting to give the appearance of faster growth. And many are flat out illegal, as with Enron, WorldCom, Wells Fargo, Wirecard and Theranos.
The craziness is exacerbated by CEO compensation. Boards, aided enthusiastically by compensation consultants, dream up incentive compensation structures to induce their CEOs to focus on increasing the stock price, regardless of whether it is already overvalued. And any CEO who doesn’t attempt to accomplish what the board-mandated incentive system sets out is, by definition, insubordinate.
Therefore, even if market participants drive the stock price to a level that makes it entirely impossible to perform consistently with the overvaluation, there are big sticks and big carrots motivating executive actions to raise expectations even higher — and generally, the penalty for not trying is worse than the penalty for trying, even though trying can wreck the company.
CEOs and their executive teams must invest aggressively in taking and keeping control of shareholder expectations. It is a tough job, but it is critical to strategic success.
While challenging, it is doable. The cleverest thinking that I have ever seen on this front came from the then-CEO of pharma giant Bayer AG, who I interviewed on-stage at a conference. When I asked him a question about dealing with the vagaries of the modern capital markets, he asserted that you must treat shareholders like children with candy. Intrigued, I asked him to elaborate. He explained that if you show children a whole handful of candy, they will badger you until to give them the entire handful — and then they will get a sugar high and be impossible to deal with. Instead, you must keep the handful hidden from sight and periodically show them one candy at a time — very carefully. Loved it! It is an awesome metaphor for managing expectations.
My advice to all CEOs of public companies (and those intending to go public) is that the best thing for they and their companies is to have a modestly undervalued stock. Being substantially undervalued is a bad thing. You will be in danger of the activist hedge fund hyenas attacking and ripping the flesh off of you until you expire. But if you have modestly undervalued stock, you will be able to make sensible investments that earn an attractive return for your shareholders. Instead, if you are Tesla and trading at nearly 38X book value, in order to earn 10% annually on that stock valuation, you need to earn 380% annually on an incremental dollar of real capital invested — and there aren’t many investments that earn 380% annually.
CEOs need to think about how long they want to be CEO and then aim to keep expectations below reality for the majority of their planned tenure and aim to converge expectations with reality as of the time they choose to step down. So, let’s imagine a CEO who wants to be in the job for ten years and has the goal of tripling the company’s stock price. Let’s further imagine that the CEO manages expectations to produce a 12% compound annual increase each year, which triples the stock price. Alternatively, the CEO takes actions that triple expectations in year one but then expectations remain flat for nine years. Despite each pattern tripling the value of the stock, in the former scenario, the CEO will be a hero while in the latter scenario, the CEO is likely to be sacked at some point in the second half of the decade for “doing nothing for shareholder value” because in the equity markets, memories are as short as the life of a fruit fly.
If the CEO gets expectations to converge with reality at the end of the period, good things happen. The outgoing CEO receives the rewards for a job well done, and the successor commences with fair value. The worst thing for a CEO to do is leave the successor with overvalued equity. People think Jack Welch did Jeff Immelt a favor by choosing him as his successor as CEO of GE over Robert Nardelli and Jim McNerney. But it was anything but. He saddled Immelt with such overvalued equity that he had no chance of being seen as a success. Immelt toiled hard for 16 long years and while he earned a lot of compensation, he will forever be known as the CEO who presided over a 16-year-long slide during which GE’s stock experienced real price decline of 4.7% compounded annually, eliminating 54% of its value over his reign as CEO. “The guy who ended GE’s century-long run” will be his reputation forever, in substantial part because of the ‘favor’ Welch did for him.
CEOs should manage overvaluation with every tool they have. Revealing the candies slowly is one way. But if the children get a sugar high anyway, then the company should sell stock from treasury until the expectations fall to a level consistent with reality. Companies do the opposite — buy stock when they think it is undervalued. But investors don’t believe the company because their actions are always intended to pump up the stock price. Companies would be more credible if they buy stock when they think expectations are too low and sell it when they think expectations are too high. They should announce in advance that they are selling because the stock is overvalued and that when the market observes them stopping, it is because the stock is reasonably valued. And they should follow the same procedure, only buying, when the stock is undervalued. The goal should always be to produce a consistently modest undervaluation.
It is a tricky and tough task to manage expectations. Every move, every interaction with the equity markets has to be done with extreme care. But external vigilance is the price of strategy freedom.