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What we call “extremist thinking” in the context of investment management has nothing to do with how the term is commonly used in society. Investment-related extremist thinking can be one of the most useful tools for analyzing complex interactions between economic variables. Often, the causal relationship between two or more variables is difficult to judge. Pushing a variable toward an extreme can help illuminate a relationship.

We have found extremist thinking as useful as the commonly accepted insight that there is “no free lunch.” The latter truism helps investors avoid schemes that promise much but in the end deliver little. Extremist thinking can have a similarly powerful effect on investment decision making.

An Example: Impact of Currency Devaluation on ADR Prices

The following thought process, which explores the relationship between currency devaluation and American Depositary Receipt (ADR) prices, shows why extremist thinking can be indispensable in some circumstances.

Consider this question: What happens to the price of an ADR if the foreign company’s home currency is devalued by 20% versus the U.S. dollar? Since ADRs are quoted in dollar terms, you may conclude that the ADR price should also decline by 20%. This may indeed occur, assuming that the company’s home currency stock price remains the same. But is this assumption realistic? Since a sharp currency devaluation and investor pessimism regarding a country’s economic prospects go hand in hand, investors are likely to sell the locally listed shares as well. The decline in the foreign stock price, coupled with 20% currency devaluation, of course, implies that the ADR price may fall by more than 20%. So far, this scenario sounds logical and, indeed, it routinely occurs in real life.

But what if we consider these questions by invoking extremist thinking? What if we push the assumed currency devaluation to an extreme, i.e., what if the local currency is devalued not by 20% but by 95%? Would the ADR price drop by 95% as well? Or, as we have seen above, could the ADR price drop by even more than 95%? Might a foreign company that, for example, is the number-one media company in its country, has a strong balance sheet, and was valued at $5 billion only a few days ago suddenly be worth $250 million or less simply because its government wasn’t able to defend the currency?

If a $250 million valuation for such a company doesn’t strike you as odd, let’s take one more step in our extremist thinking. Imagine a different foreign company that owns 10% of the real estate of an entire country (let’s say Argentina), has no debt and is profitable. Also imagine that there are no calls in the country to confiscate property from investors. If the home country’s currency is devalued by 99.999990%, should the company’s market value decline from $10 billion to $1 thousand? (Hint: We would love to buy 10% of Argentina’s land for $1,000, no matter how worthless the local currency!)

The following must be true to prevent someone from buying 10% of Argentina for $1,000: The Argentine company’s stock price in local currency terms must soar post-devaluation rather than decline, contrary to our initial instinct above.

Extremist thinking has just helped us debunk a widespread stock market misconception—that stocks of companies in countries undergoing major currency devaluation should fall not just in dollar terms but also in local currency terms because of the deteriorating home-country economic situation.

Of course, just because investors may be wrong to sell such foreign companies in local currency terms, there is nothing to prevent them from doing so anyway. However, such behavior may create a unique buying opportunity.

Next time a currency undergoes major devaluation, we will certainly take a look at how the ADRs of affected companies respond. If the ADR prices drop by more than the currency decline, and if the companies own real assets (such as raw materials, land, or industrial equipment) and have a healthy balance sheet, we will take a close look. In late 2002, when the ADR price of Cresud (NASDAQ:CRESY), an Argentine agricultural company with large land holdings, was cut in half due to the devaluation of the Argentine peso, we found the shares a compelling value. Cresud had a solid balance sheet and was trading significantly below tangible book value, suggesting that investors had overreacted. A year later, the ADR price had increased from $5 to $15.

Keynes’s “Beauty Contest”

John Maynard Keynes’s “beauty contest” refers to the attempt by investors to guess what other investors will do in the future, and to “beat them to the draw.”

Extremist thinking makes it quite clear that the “beauty contest” is a zero-sum game: If all investors focus solely on guessing the future behavior of other investors, there will be no reason for anyone to allocate capital based on underlying fundamentals. If all that mattered to each participant’s investment decision was the perceived future behavior of others, there would be nothing to stop investors from making the weather, the outcome of the Super Bowl, or the spelling of a company’s name (think “.com”) the criterion upon which “beauty” (investment merit) is judged. Capital won’t flow to projects promising the best risk-adjusted return; instead, capital will flow to companies most in vogue.

Extremist thinking therefore shows that the self-referential guessing game in which so many investors engage does nothing to make capital allocation in the economy more efficient. Making money by engaging in a beauty contest requires one to outsmart other investors—it’s the ultimate zero-sum game.

By contrast, investing in companies based on their underlying value puts one in a position to make money because the investee companies will pay dividends or reinvest their profits into attractive projects.

While many observers contend that investing is a zero-sum game no matter what strategy investors employ, extremist thinking suggests that investing based on fundamentals is not a zero-sum game because it makes capital allocation more efficient. This increases market-wide returns. If all stock market participants focused only on fundamentals, investors might be able to earn 10% from stocks, on average, rather than perhaps only 2%, on average, if all of them engaged in a beauty contest. Market reality lies somewhere in-between.

Explosion of Indexing Vehicles

The case for investing in low-cost ETFs and index funds often rests on the assertion that investing is a zero-sum game and that the only way to win is to lower costs. While it’s true that the mutual fund game is by definition a zero-sum game, extremist thinking shows that indexing is not all benefit and no cost.

There is a tradeoff between lowering costs via indexing and lowering returns due to inefficient capital allocation. Consider this extreme: Everyone invests in an index fund. We know that everyone would perform the same. Everyone would incur low costs and match the market-average return. But what would the market-average return be? Extremist thinking suggests it might be as low as zero or worse.

If everyone were invested in an ETF or index fund, there would be no mechanism for pricing assets. Who would say what a company was worth? Who would determine which companies should be in the index? Who would invest in a private company seeking to go public if such a company has no market value prior to the offering and therefore has no index fund constituency?

In other words, an index fund is a dumb investment vehicle. An index does not care about returns on capital or any other variable related to invest merit. An index cares only about descriptive variables such as market capitalization, geography, or industry affiliation. If index funds could invest without moving market prices, they would have no effect on the efficiency of capital allocation in the economy. But since index funds do move prices, and since real capital is tied up in them, those funds make worldwide capital allocation less efficient. Given the amount of capital currently invested in ETFs and index funds, the magnitude of the negative effect is probably small but not negligible.

In this case, extremist thinking has illuminated the tradeoff investors as a group face with index funds. There is a point at which the fee-lowering benefit of index funds is outweighed by the cost of less efficient capital allocation. We can argue where that “point of indifference” lies on the continuum from 0% to 100% of index fund assets as a percentage of total stock market assets. Extremist thinking does not specify such a point, but it does make it clear that such a point exists.

Source: Extremist Thinking Can Make You a Better Investor