In 1991, a Goldman Sachs limited partner, Barrie Wigmore, released a study that attempted to determine what factors drove the stock market’s above-average returns in the decade of the 1980s. After carefully accounting for earnings growth, interest rate declines, M&A activity and analysts’ “too-rosy” forecasts, it appeared a full 38% of the shareholder value created in the 1980s remained unexplained. Dubbed the “X” factor, this mysterious driver of value left Wigmore and the Wall Street Journal1, which published a feature article on the study, at a loss. Given overwhelming evidence of well-functioning capital markets, it appears completely unsatisfactory to attribute such a large component of share price performance to some unidentifiable and seemingly inexplicable force2.
Fortunately, we believe there is an answer to this problem. However, to understand the solution there must be a recognition that share prices are not set by capitalizing accounting-based earnings, which are at best flawed and at worst substantially misleading. It appears that this was precisely the paradigm under which both Mr. Wigmore and the Wall Street Journal were operating.
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