SERIOUS MONEY:In investment, there is no Holy Grail and there cannot be in highly competitive markets, writes CHARLIE FELL.

OSCAR WILDE wrote in Lady Windermere’s Fan that a cynic is “a man who knows the price of everything and the value of nothing”.

The same could be said of performance-challenged investment managers who use valuation metrics with little theoretical foundation or predictive ability.

The analysis is often based on shortcuts or rules of thumb, leaving one with the distinct impression that those investors who do not know how to measure settle for wanting what they can measure. Is it any wonder that a basket of consumer goods has outpaced the bulk of said managers over the past decade?

The usefulness of any metric as a measure of value hinges critically on the satisfaction of a number of key tests.

Firstly, any valuation indicator must be measurable such that it is possible to say whether stock prices are cheap, expensive or fairly valued relative to fundamentals.

Secondly, the valuation indicator must be justifiable on solid theoretical grounds; otherwise, any investment signal derived from the metric may simply be a function of chance.

Thirdly, the valuation measure must be mean-reverting such that there is a reasonable probability at high or low values that the indicator will reverse direction in the future.

Finally, the metric must demonstrate the ability to predict future returns insofar as mean reversion occurs through prices and not fundamentals.

It is important to recognise that the metric’s predictive ability should be high but not too high; otherwise, prices would be expected to adjust automatically such that the valuation tool would lose its capacity to boost performance.

This point is often overlooked as investors waste time in pursuit of investment’s Holy Grail. In reality, there is no Holy Grail and there simply cannot be in highly competitive markets.

How does the price/earnings multiple, the most widely used valuation indicator by investment professionals, measure up on the key tests that determine an indicator’s usefulness as a measure of value?

It would appear at first glance that the price/earnings ratio is easily measurable and therefore passes the first test. But this is not so when one considers that accounting earnings are unreliable, while the use of 12-month profits, be they backward- or forward-looking, means that the resulting multiple cannot be used to determine whether stock prices are cheap, expensive or fairly valued.

Use of the multiple would appear to rest on solid theoretical ground, given that the earnings yield or inverse of the price/ earnings ratio approximates the long-term real return expected by equity investors at current prices.

However, this is only the case if the profit number used reflects sustainable earnings power and if the price/book ratio is at unity.

The use of 12-month profits, which do not represent sustainable earnings power, undermines the suitability of the calculated ratio as an indicator of value.

Furthermore, the standard analysis is deeply flawed from the outset. Many investment professionals calculate the price/earnings ratio on one-year forward operating earnings and then compare the resulting multiple to an historical average based on trailing 12-month reported earnings.

Operating earnings are computed before exceptional and extraordinary items, while reported profits are calculated after such charges. This serves to artificially lower the multiple on the former relative to the latter.

The error is exacerbated through the comparison of an historic number with a forward estimate of profits. Thus, a typical investment manager’s analysis must be considered null and void.

Not only is the basis for comparison flawed from the outset but the ability to predict future returns is also limited by the fact that the adjustment to a high or low multiple typically occurs through earnings and not prices.

In other words, exceptionally high or low multiples usually reflect cyclically depressed or inflated profits such that robust earnings growth in the intermediate term is the most probable outcome when the multiple is unusually high, while a downturn in profits is more frequent when it is low.

There appears to be little method in such madness but fortunately there is a better way.

The use of a price multiple based on trend earnings has been highlighted several times in this column so a discussion of its merits will not be discussed here.

Instead, investors should take some time to consider the advantages of the Q-ratio developed by the late Nobel laureate James Tobin in 1969.

The Q-ratio measures the market value of equity relative to its replacement cost. A fundamental relationship should exist between the market value and replacement cost as firms in the long run should be valued at their cost of creation and, therefore, the Q-ratio should hover around unity, given rational expectations.

The “law of one price” should ensure that the relationship holds over long horizons as a ratio above/(below) one implies that it is cheaper to invest/(buy) in new/ (old) capital rather than buy/ (invest in) existing/(new) capital, and exploiting the arbitrage opportunity in either case should push prices back toward equilibrium.

However, analysis of the data indicates that the adjustment takes place through a change in prices rather than changes in the capital stock such that the Q-ratio predicts future returns.

The recent advance in stock prices off their March trough has seen the Q-ratio jump from an 18- year low back up to its long-term average. This may cause some to conclude that the coast is clear, but the verdict of history suggests that, once the ratio falls below its historic average, the entrenched momentum ensures that it remains there for a protracted period and continues to move lower in the medium term.

This confirms that investors are not witnessing the birth of a secular bull, so enjoy the cyclical upturn while it lasts.