The Power of "Q"
Say what you will about John Maynard Keynes (1883-1946). However loathed (or loved) as an economist, he was, undeniably, a great investor. Keynes (pronounced “canes”) piloted the endowment fund of King’s College through the dark years of the Great Depression. He steered the fund to 10-fold gains, excluding income (which the college spent).
Keynes also divulged a key insight that helped him do it, back in 1936.
“There is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased,” Keynes wrote. On the other hand, there is an incentive to spend money on projects, even “an extravagant sum, if it can be floated off on the stock exchange at an immediate profit.”
In that paragraph is an idea so powerful it helped Keynes beat the Great Depression. An American economist named James Tobin polished up Keynes’ insight and popularized it. In 1969, he created Tobin’s Q, which summed up Keynes’ idea in equation form:
Market value of company / replacement value = Tobin’s Q
Replacement value is the cost to build an asset from scratch. You may recognize this now. As Keynes surmised, if you can buy, say, a steel mill for $500 per tonne of capacity in the stock market when it costs $1,000 per tonne to build one from scratch, you buy the stock.
Most businesses will trade for a premium to replacement value because of the time and risk of building from scratch. But to be most conservative, we want Tobin’s Q to be under 1. This works because the market adjusts over time as market participants buy the cheaper asset. This is also where you tend to see buyouts, which is exactly what happened with PotashCorp.
When I recommended this stock to the subscribers of Capital & Crisis, it was selling for about half of its replacement value (a Tobin’s Q of 0.50). BHP made a play for it, the gap closed and the subscribers who acted on my recommendation nearly tripled their money in less than two years.
We own many stocks with Qs under 1 (CVA, KRO and OI, to name just a few buy-rated tickers). And many big gains on the back page are in stocks we picked up at low Q ratios (including TIE, MEOH and GSM, to name three). We also want to avoid the extremes on the other end of the spectrum.
This takes us to the second part of Keynes’ observation. Let’s look at how this works with a real-world example from the telecom industry of the 1990s. At the height of the boom, telecom companies commanded a stock market value of, on average, $6 for every $1 spent building networks. So, no surprise, the telecom industry spent money like drunken sailors.
Level 3 spent $10 billion building out a fiber-optic network. It had no revenues, yet enjoyed a stock market value of over $30 billion. KPN West spent about $2 billion, and the market valued it at $11 billion. Global Crossing traded for eight times what it spent on its network. With that kind of incentive, the industry poured some $500 billion toward creating 150 new carriers — 40 of which were public — and eight new national networks (with more than 100 miles of optical fiber) from scratch.
As author Edward Chancellor summed up: “When a hole in the ground costs $1 to dig but is priced in the stock market at $10, the temptation to reach for a shovel becomes irresistible.” Of course, the whole thing ended badly. The tech bubble finally burst in 2000. Bankruptcies and massive losses soon followed.
And this is just one example from many. I’ve yet to find a stock market bubble from any country — from any era — that doesn’t show the same stripes.
Despite Q’s powers, I don’t find many investors using it. Maybe it’s because Q takes some digging to figure out. That’s part of its appeal. One group that does use it is Marathon Asset Management. The folks behind Marathon put together a book with Ed Chancellor in 2004. It’s called Capital Account: A Money Manager’s Reports From a Turbulent Decade, 1993-2002. If you want a more-detailed look at how this all works, I’d recommend the book to you.
The money managers at Marathon are the only ones I know of who put Tobin’s Q — which they call a “truly remarkable investment tool” — at the heart of their investing process. “The stock market is really a market in replacement capital,” they write. It gives off signals where investment dollars get the biggest bang for the buck, for good or for ill, as we’ve seen.
Marathon has used these signals to great effect. In May 2000, Marathon warned the “capital flows unleashed by the new economy” — all that money flowing into tech, telecom and media — would lead to big losses for investors. High Tobin’s Q ratios kept Marathon away. Instead, they steered clients to stocks in which Tobin’s Q was low. At the time, this meant hard assets — such as commodities. It was a smart move, as hard assets enjoyed a stellar decade. Meanwhile, tech, telecom and media blasted away fortunes.
What does Tobin’s Q say to buy today?
US housing. As it happens, Tobin used the housing market to explain how Q worked, which is worth recounting, given what we’ve been through with the housing bubble. Tobin talked about how home prices far in excess of the cost to build them would lead to a building boom as builders took advantage of the profits available. Over time, though, the market would adjust. “In the longer run,” Tobin wrote, the building boom would “bring market values in line with replacement costs, lowering the former and, possibly, raising the latter.”
This is exactly what happened. Prices came way down. The wide profit premium that came from building houses vanished. Today, in some markets, houses trade below replacement cost — a Tobin’s Q below 1. And that’s why we’re building new houses at a rate of around 500,000 annually, down from a 1.6-2.0 million run rate pre-bubble.
If he were alive today, Keynes would be a buyer. Following the indicator inspired by his idea, count me bullish on housing as well.