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Historical analyses of stocks for valuation purposes are contingent upon relevant comparisons, or comparisons of “apples with apples.” Surprisingly, that’s something missing in valuation studies, which typically compare today’s apples with apples picked years ago. In effect, what they are comparing is apples with oranges. Conclusions drawn by comparing current stocks or earnings with those of other time periods tend to be skewed, depending on when the analyses began.
Wall Street strategists often take this easy route. A typical headline might read: “Stock prices are high compared to stock prices in 1990, so investors should avoid stocks right now.” That’s lazy analysis that reveals nothing of value for investors.
Another example: “European companies are trading at a P/E of 12 versus U.S. companies trading at a P/E of 17, so investors should own European companies.” Again, that’s comparing apples to oranges. The European economy is totally different from that of the U.S. The only thing that's consistent is the P/E, but what’s being measured is actually very different.
Among Europe’s largest 20 companies, only two are technology companies, representing a combined market capitalization of $600 billion. In the U.S., eight of the 20 largest companies are in technology and their combined market capitalization is $14.7 trillion. That’s roughly 25 times the size of the two European technology companies!
Using the two economies to compare market capitalizations is senseless.
Early accounting regulation
The economic and business environments of the past were markedly different from today for a variety of reasons. Equating today’s economy with that of the past is an analytical miscalculation that provides little or no insight. It’s hard to believe, but prior to the stock market crash of 1929 and the subsequent formation of the SEC in 1934, accounting standards among U.S. companies were essentially non-existent.
While the Companies Act of 1900 required all registered companies to appoint “auditors” to report on their balance sheets, there were no professional qualification requirements for the auditors, so reporting was often assigned to the least busy member of management. The reporting obligations were never truly formalized. Double-entry accounting and other abuses were commonplace.
In effect, companies decided what constituted proper reporting on an individual basis. Lacking independent oversight, the undisciplined reporting practices continued unabated until the passage of the Securities Acts of 1933-1934 and the formation of the SEC. The Commission eventually became a regulator that insisted on full disclosure, transparency and historical cost accounting that avoids misleading disclosures on financial statements.
After World War II, America’s economy was primarily manufacturing-based. Now, less than 15% of the nation’s current economy is based on manufacturing. This is just one example of how accounting dissimilarities among different industries skewed historical comparisons.
The early 1960’s saw Congress enact an “investment tax credit” to help stimulate the economy via internal investment by companies. In response, the Accounting Principles Board (APB) voted to require that the credit be subtracted from the asset cost, and not be included in current earnings. However, pressure from accounting firms and the Kennedy Administration forced the SEC to announce it would allow either accounting method – historical cost accounting or current value accounting – to be used by companies. The decision humiliated the APB, but it is only one of many such legislative defeats, primarily caused by persistent industry lobbying.
In 1973, the APB was replaced by the Financial Accounting Standards Board (FASB). Originally formed by the Securities Exchange Act of 1934, FASB was a joint effort of the American Institute of Certified Public Accountants (AICPA), the American Accounting Association (AAA) and the National Association of Accountants (NA).1 The three private organizations merged into a single FASB entity through the Financial Foundation Act in 1973. The primary role of FASB was to set and improve accounting standards for public and private companies, a change described by some as “the need for consistency and accuracy in financial reporting.”
Talk about something being self-evident.
These events ultimately led to the 2002 passage of the Sarbanes-Oxley Act (SOX). Virtually everything that occurred prior to 2002 had little or no relevance to modern business accounting.
Historical financial comparisons to pre-2002 conditions are the equivalent of a comparison between a 1961 IBM Selectric typewriter and a 2024 Apple computer. They both provide communications capabilities, but as any writer will tell you, the similarities end there.
Apples to apples
Advisors who make stock recommendations using historical or international correlations make decisions based on irrelevant data. It’s the equivalent of comparing modern pedigree analysis of thoroughbred horses with that of horses that existed 50 or 60 years ago, prior to industry-wide regulation of performance-enhancing drugs.
Different start dates result in dramatically different assumptions. Most historical analyses of stocks begin back in 1926, the year Standard & Poor’s launched the 90-stock composite price index, later expanded to include 500 of the largest U.S. companies (large caps) in 1957.
Using 1926 as the start date, small-cap stocks – represented by the Ibbotson Small Company Stock index from 1926-1978 and the Russell 2000 index from 1979-2022 – would appear to have outperformed large caps by roughly 2% (12% to 10%).
But that analysis is distorted by the fact that the Ibbotson index, initially represented by just a few companies, got off to a huge lead over large caps during the first decade. Starting an analysis at a different point in time would provide a markedly different result.
Think of a major league pitcher with an earned run average (ERA) of 3.50 at year’s end, a statistic comprised of perhaps 30 or 35 starts. Like small-cap stocks, the hurler may have gotten off to a rousing start in April and May, compiling an ERA of 1.50 during that period. However, as the season progressed, his ERA steadily rose, and by year’s end, he was getting hit to the tune of an ERA near 6.
Depending on what month an analysis of his year began, the conclusion of what kind of a year he had would vary greatly. Just ask his agent, arguing with management for an annual raise after his client was bounced around like a ping pong ball the final few months.
Advisors that ignore – or are unable – to conduct bottom-up financial analysis will continue to mistakenly base their valuation assertions on dated charts and calendars with predictably flawed results.
Ryan Zabrowski, author of the book Time Ahead, is senior portfolio manager at Krilogy, based in St. Louis. He can be reached at [email protected].
1 https://www.fasb.org/about-us/about-the-fasb
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.