Time to Invoke Jim Tobin’s Q Ratio
While working for my MBA (60 years ago) my advisor touted me off calculus unless I was going for an economist. “Nobody uses much integral calculus on the Street kid, he said.” “It’s who is doing what to whom in the back seat of the car. What’s ahead for the next 12 months is what you live by.” This was the second-best advice I ever got.
Academics’ talk of random walks, risk premiums and efficient markets leaves me cold. Countless assistant professors who must publish or perish, concoct papers riddled with equations published in the Financial Analysts Journal. I stopped reading it 20 years ago because of such gibberish.
But, I won’t trash all academics. At a graduation ceremony at Bard College, years ago, I had the pleasure of introducing James Tobin, the economist who birthed his Q ratio. At lunch I was telling Tobin how much I admired the elegance and simplicity of his insight. Briefly, The Q ratio has to do with the capital stock or infrastructure of the country and compares it to the market value of corporate equity.
When the market value of the Big Board is less than the replacement cost of corporate hard assets, rest secure, the market is undervalued. For much of the eighties this was true and it spawned the Mike Milken hostile takeover binge. Operators with brass gonads waxed rich. Leon Black came out of Milken’s office while Carl Icahn was one of the early “greenmailers.”
Consider, the Q ratio now stands well above par. Actually, we’re talking double par which is why you see more discriminating takeovers. Today, you can finance a tranche of takeover debt near 5%, but in the eighties this debt cost 8% to 9%.
Market bulls pooh-pooh Tobin as a quant and obsolete. How do you capitalize Coca-Cola’s trademark or an ethical drug house patent on a Covid-19 vaccine or cloud computing patents? This is valid, but Tobin’s right, too, because his insight is on how businesses are valued… fairly valued, under or overvalued in successive business cycles. This is long cycle stuff you file away, but never discard.
The problem for money managers today is we’re living in anything but a pre-1914 Gilded Age. The market sells at 2 times book with a paltry yield, hardly more than 10-year Treasuries. Internet properties like Facebook sell at 6 times book value, and at a valuation premium to the S&P 500 Index (but it’s coming down to maybe a 1.5 times premium from 2 times not so long ago.)
Very few of us care to face the facts that the market is richly priced. White shoe wealth counselors like JPMorgan Chase have underperformed their pie chart indices past few years, but rest unruffled. They know that history is on their side. Even if you come in at the top of a market cycle, after a decade invested, your rate of return can exceed Treasury bills. So what? Ten-year Treasuries yield under 1.5% and 2-year paper is measured in basis points (20) not percentages.
The old Gilded Age ran from 1870 to the eve of World War I, 1914. My 60 years as a player was filled with harrowing events like the Cuban Missile Crisis, the financial meltdown of 2008-’09 and even 1987’s Black Monday, a 22% schmeiss, overnight, for no good reason except institutional stupidity.
In every market crisis I remember, the market sold down to book value, yielded 5% and carried a price-earnings ratio of 10. I bought into the Cuban missile affair. Over-leveraged myself with Xerox and Polaroid and came up roses. But, all I had to my name was $50,000. I was still young enough to leave the Street and go back to a newspaperman’s life.
Today, things are different. I’ve a little more gelt on the table. I’m 89, still an active operator, but I didn’t use leverage. Maybe, that time comes again, but I see no Gilded Age around the corner. I’m over-concentrated in sectors like the financials, but I’ve taken down oversized positions in Amazon, Facebook and Alibaba.
Citigroup still sells under book value because of its past stupidities, but Goldman Sachs has moved from under book value to a premium past 12 months. Elevating interest rates hurts everyone but banks and brokers so I hang in. Same goes for JPMorgan Chase and Bank of America.
What to do with vicious cyclicals like Freeport-McMoRan and Halliburton? They were $5 stocks a year ago, now trading in the twenties and thirties. I’ll cut ‘em back as I go long term. Consider, several Internet and tech houses like Microsoft, Amazon and Alphabet past 5 years ran around the clock 300% or more. I’m a skeptical holder, but these babies still can appreciate with their earnings. The wild valuation period is history.
Despite escalating interest rates, I’m not selling my BB debentures maturing over 5 years. They’re money good and competitive with comparable Treasuries in terms of historic yield spreads.
Repeat my mantra: “Nobody promised me a rose garden.” The Q ratio signals trouble in the sky.
Sosnoff and/or his managed accounts own Sosnoff and/or his managed accounts own Facebook, JPMorgan Chase, Amazon, Alibaba, Citigroup, Goldman Sachs, Bank of America, Freeport-McMoRan, Halliburton and Microsoft.