Opinion: Current valuation techniques may become irrelevant

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Tuesday, February 1st 2000, 12:00AM

by Philip Macalister

The last quarter of the old millennium has been appropriately dramatic. The bear trend which seemed to be developing in the third quarter of 1999 came to quite a startling end in the autumn, but we were witnessing much more than a normal market turn. Indeed we may well have seen one of the great changes in market structure and behaviour and one which our own analysis of both the economy and market had predicted. Observing an index such as the FTSE All-Share disguises what has really happened: a two tier market has developed in which the general run of equities has not performed particularly impressively while growth stocks, especially in the technology sectors, have outperformed spectacularly. We must now ask ourselves whether we have seen a typical sector bubble or the beginning of a trend which may last for a generation.

The timing of the turnaround in market behaviour can be traced back to Mr Greenspan’s evidence that it was becoming clear that advances in productivity were indeed having a benign effect on US inflation. Not only did this indicate to markets that upward pressure on interest rates might be less than expected, but for the first time a senior official was confirming that new factors were influencing the economy. While his message to the market gave the signal for recovery it was the extent of recovery and its almost exclusive concentration in high-tech stocks which carried the important message. Especially in the UK it was plain that at last major institutional investors were accepting that the old beliefs were being cast aside and that "growth", the "new economy" and change radical enough to be called "revolution" was upon us.

We have commented several times that a revolution is occurring in the economy. The movement in the market shows that the revolutionary state is now recognised and confirmed by institutional investors who have been the major conservative force in their unwillingness to come to terms with the fact that change was under way. If indeed the events of the millennium end can be correctly interpreted in these terms, and we think they can, then we are seeing only the beginning of a vast trend which may take many years to work itself out.

In terms of the real economy only the beginning of change has yet occurred. E-commerce is expected to develop rapidly, the efficiency with which an enterprise can be managed will rise and competition will intensify. The purchaser of goods will be dramatically empowered and the middleman will be squeezed and squeezed again. These effects will all occur against a general background of economic liberalisation and a long period of price stability. For many commodity goods, price decline must be expected. Excitement about the potential gainers from this change should not blind us to the potential losers in the process. Many service industries have long enjoyed fat margins and have seemed secure in their position in the economy but the sudden ability of their consumers to gain access to other providers will result in rapid change. We must be as conscientious in avoiding the losers as well as finding the gainers.

If the market pattern of the last quarter carries the clear message that the move of investors to growth stocks and to IT revolution exposure is now under way, then the behaviour of individual stocks and shares also carries powerful if disturbing messages for the future. We have witnessed the growing ineffectiveness of traditional means to value individual stocks.

Since the early 1930s the historical growth in earnings per share was used as a benchmark against which the future earnings flow could be measured – the price earnings ratio reflected this method. In a revolutionary condition, as now obtains, the companies which will be industry leaders in five or 10 years time may not even possess historical profit records, and in some cases do not have profits to report at present. This is why current valuation techniques can give seemingly absurd measures. The IT revolution is so radical in its impact that it is necessary in some cases to buy stocks on the basis of the role that they will play in the developing new economy. Concept, potential market size and potential market growth are the measures that must be used in measuring these investments.

We do not suggest that portfolios should be wholly invested in stocks of this kind. The normal rules of risk diversification must continue to apply. But we must recognise that change in the real economy, and now in markets as well, should not be inhibited by commentators who find it difficult to come to terms with the major changes which have happened and will continue to occur. For that is the real message, the performance of IT or high-tech stocks only began in the last quarter of last year, and the trend is underlain by massive real changes which, having begun their journey into the next century, will continue for a generation.

Whilst the first surge of outperformance may well have run too far, any weakness is likely to be short term as long term investors use the opportunity to build holdings.

 London-based Taylor Young Investment Management Limited is regulated by IMRO

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