Investing With Mr. Spock

Live Long and Prosper

With the death of Leonard Nimoy (pictured above as Mr. Spock on Star Trek) last week, I have been thinking, once again, about the unwelcome role that emotions can play in our investment decisions, and how much prosperity, as measured by portfolio returns, might be enhanced by having the logic-driven Mr. Spock as a stock-picking partner. Mr. Spock's Vulcan logic was leavened, but never eclipsed, by his human side (his mother was human, his father Vulcan), and it was this potential for inner-conflict that gave the series some of its best Spock moments. Given that we are all humans with enough emotional baggage for own own versions of intergalactic travel, it would be wise to get in touch with--and cultivate--our own "Inner Vulcan."

Yes, we need to keep our emotions in check when it comes to investing, but it is also important to possess a keen understanding of the emotions of others, particularly those others in whose hands we place our financial fate when we own stocks that trade in a market. Warren Buffet advises that we be "fearful when others are greedy, and greedy when others are fearful." That's another way of saying buy low and sell high, that the best time to buy stocks is when no one wants to own them. Here it is helpful, though, to distinguish between an individual stock and the stock market. Major market sell-offs have a way of taking down the good stocks with the not-so-good ones, and if we can keep our heads under those conditions we might find some buying opportunities. We might suspect that the declining share price of a company with stellar sales and earnings growth is illogical, at least when the company's business is domestic and the market is having an emotional tantrum over the latest crisis in Greece. And while the strong dollar is taking its toll on the earnings of the multinationals, it would not be logical to apply such concerns to companies that don't have to convert their foreign earnings into U.S. dollars.

We have to consider, also, that an irrational exuberance driving the market higher could just be an expression of emotions run amok. The standard answer these days to a roaring stock market is our old friend, TINA (There Is No Alternative). TINA says that we can't get a return anywhere else, especially when we consider that the real bubble likely resides in the bond market. But investors always have an alternative, and they just might pursue it if they are gripped by the fear that a sinking stock market might inflict more pain than a slightly negative real return in bonds. Or they could hide their money under the Tempur-Pedic. And is it not possible that the actions taken due to unbridled fear could be the same ones called for by an unalloyed logic? Or that what we might chalk up to an emotional frenzy of greed has its own foundation in calculated logic?

What would Mr. Spock say? Perhaps he would agree that the valuation of Tesla Motors (TSLA, $203) is very different from that of Celgene (CELG, $121). TSLA has current losses and a forward Price/Earnings ratio of about 200. CELG, a biotechnology concern, has current earnings and a P/E of 50, with a forward P/E of 25. CELG has said that it expects to earn at least $12.50 per share in 2020. Of course, a lot can happen between now and 2020--as parents on a family road trip often have to say to the eager kids in the back seat, We are not there yet. There is always risk, and each year we add to the time horizon to justify current valuation adds even more risk. Stock prices reflect the discounted, present value of what is expected to happen in the future, and it is here that we can put on our pointy ears and apply some logic. Just how much of a rosy future does a stock price seem to be discounting? Skeptics of Tesla's valuation will say a lot. Someday TSLA will have to trade on its actual earnings, and we just don't have a clear picture now of what those earnings might be. CELG appears to be the more logical investment; if, IF the company can realize its stated goals over the next five years, it looks like a bargain. To put it another way, both companies may have very bright and promising, profitable futures, but what are you willing to pay today for those yet-to-be-realized futures? It appears that we are being asked to pay quite little for Celgene's 2020 earnings.

Investors often make the mistake of focusing on current valuation, as measured by the current P/E ratio, alone.This thinking would conclude, ostensibly, that a stock trading at 30 times earnings is more expensive than a stock trading at 10 times earnings. What's missing here is context, particularly the company's growth prospects. If the stock going for 30 times earnings is actually growing at 30%, and the stock at 10 times earnings is growing at 5%, guess which stock is "cheaper." That shifts the conception of risk a bit, as the more relevant risk may not be valuation risk, but instead execution risk. The logical approach to valuation is to ask, relentlessly, what is being discounted. The future always lies beyond what the eye can currently see, but it shouldn't lie beyond what the mind can logically and reasonably envision. When a stock's price seems to be discounting an ill-defined perfection that tempts us nonetheless, it might be time to suspect that our emotions had crept back into the room. Then it would be time to look elsewhere. That would be the logical thing to do.

Last night my wife and I were discussing Leonard Nimoy, and I persuaded her that we should delay gratification of the new House of Cards season 3 by about 50 minutes to view an old Star Trek episode on Netflix. We chose "Journey to Babel," my favorite installment of the original series and the one that introduced Spock's parents. The story has the combination of interpersonal drama and high adventure in space that made for the best episodes. The U.S.S. Enterprise is taking a group of ambassadors from various planets to what amounts to an intergalactic version of the United Nations. One of the ambassadors is murdered, Spock's father has to have emergency heart surgery and a transfusion of green blood from his almost-estranged son, Captain Kirk is stabbed, and Uhura is picking up strange communications from inside the ship as the Enterprise is followed by an unidentified and unwelcome vessel. Good stuff.

Life is short. Get busy. (And please, Live Long and Prosper.)

Jim

Disclosure/Disclaimer: My family members and/or I own shares of CELG. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.

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