Relative Valuation

"All things are relative."
- Albert Einstein

"All relatives are things."
- Groucho Marx

"My relatives took all my things."
- Rodney Dangerfield

I've gotten quite concerned that I'm increasingly seeing only an appeal to relative valuation in the analysis of stocks listed in Hong Kong and Shanghai. So for example, yes, Company A trades at 70 times earnings, but other peers trade for 90 times earnings, so Company A is cheap and should be bought. Another theme is that if Company A is listed in Hong Kong and valued at $10B, but is also listed in Shanghai (or Shenzhen) at $15B, then the Hong Kong shares are a relative bargain and so they should be purchased. Not dual listed? No problem. It's still a bargain because it probably will be dual listed in the future, and of course the A shares will be worth more and so the H shares are still a bargain even now.

Is this not the same logic we find in all asset bubbles? Back in the dot.com era, I recall reading many analyst reports that stated that while the company in question was just started two years ago and had never shown a profit, nonetheless the company was only trading at 50 times sales, while a similar company was trading at 80 times sales. It was then presented as a tremendous bargain.

(Now to be sure, fallacious reasoning does not necessarily imply that the conclusion is incorrect. On the other hand, it's a pretty strong red flag! We should not presume to be so lucky as to accidentally arrive at the right conclusion after using faulty logic!)

Broadly speaking, of course, relative valuation is fundamental to how we value anything and should not be thrown out altogether. To be more precise, the root cause of the relative valuation phenomenon in asset bubbles is not so much that a relative valuation is made, but that the comparison is usually restricted to a conveniently small set of variables that may themselves all be outliers. In the late 90's, Internet companies were compared with selected metrics of other Internet companies, but they were not frequently compared with a variety of traditional valuation techniques and with companies outside the sector and with companies from other time periods. Had this been done more often, the valuations would certainly not have looked so attractive.

At the peak of the housing bubble, there were houses in our area that sold for $600,000, while identical houses on the same street rented for only about $1,500 per month. $600K houses were extolled as bargains because by using only a comparable sales method, they were simply compared with other houses listing for $630K. However, these same houses looked frighteningly expensive when viewed on a rental basis or by replacement cost, to say nothing of whether the prices were out of whack with the income of residents in the area.

As such, I've shuffled my equity portfolio a bit this past week, which is a rather rare thing for me. I've sold all my China positions that I held directly: CEO, SNP, and ACH. My position in CEO more than doubled in a matter of a few months, while SNP and ACH both more than quadrupled since I purchased them. I've redeployed about 10% of the proceeds into AIB and BCS, and the rest of the money will await further analysis. All changes are reflected in the left nav bar.