For a long time I have been fascinated by the influence of perception on equity markets, my focus however was on the comparison of perception to reality and the distortions a divergence between the two could create.
Recently however I noticed that I have not given enough attention to the concept of reality; since we all perceive the world differently, it behoves me to ask if there is a clear cut truth in the midst of the sea of perceptions from various participants?; in my search of an answer I have focused on empirical calculations as basis for reality; but even this mathematical certainty is questionable when perception enters the picture, example:
Company A is a money losing enterprise operating in an exciting growth market (example social networking today).
Company B is a profitable enterprise operating in a mature or unattractive market (traditional media)
Often we will witness a situation where Company A enjoys an excessively elevated valuation in relation to Company B, despite the fact that Company B is a profitable and has a long history of stable operations and reasonably stable outlook.
Naturally Company A valuation is driven by a perception of strong growth going forward; it is possible that the industry is showing empirical evidence in terms of growth, and it is also possible that the company is showing real revenue growth (albeit non profitable). Company B on the other hand is perceived to be in a mature industry and thus not worthy of a valuation close to Company A.
A value investor will naturally invest in Company B and avoid Company A; driven by real value fundamental analysis a value investor will come to the conclusion that Company B is undeservedly discounted and the market will eventually perceive this disconnect and award the company a proper valuation.
While the above logic seems sound; it is important to go back to the concept of truth and perception; since reality is a fabrication of divergent perceptions; there is no guarantee that the perception of Company B will revert to its empirical value or at least there is no guarantee that perception will shift enough to impact the price positively; this is why an undervalued company require a catalyst (something we can label as perception shifter, with enough catalysts perceptions will nudge in a certain direction), however micro and macro catalysts are beyond the scope of this article.
Since reality is composition of diverse perceptions; perception is reality and reality is perception; hence when company A is trading at an excessively expensive valuation, while frustrating for value investors, this valuation is reality at this moment in time and this is not just an obvious observation, but this observation has enormous implications on empirical reality.
With an excessive valuation Company A is able to change its own fundamentals; by using its shares to acquire an undervalued business; or raise cheap funding to fund its growth thus gaining a clear competitive edge.
Meanwhile Company B could languish due to limited funding opportunities; or possibly be acquired by company A thus depriving the value investor of a chance of investing in the shares all the way to their true potential valuation; it is also possible that Company B could fully go out of business if the company was unable to role its debt for example, assuming it had a certain amount of leverage, this is especially true in the banking industry where the perception of a weakened banned can lead to a self fulfilling prophecy; Bank of America (NYSE: BAC) and Societe Generale (OTC: SCGLF.PK) are current example of banks that maybe going through such an experience.
t is clear from the above that perception could lead to real changes in the underlying fundamentals and thus alter empirical reality; thus investing with a full focus on fundamentals while ignoring perception could lead negative surprises if perception is not accounted for or hedged against.
It is also worth noting that perception could be very fickle at times; thus a business like Company A could have a limited window to alter the underlying reality by undertaking concrete actions to that aim within the window, a failure to do so will likely mean a sharp perception adjustment is at hand if the perception of the company proves to be false.
This is why it is vital for investors to evaluate companies both from a fundamental prospective as well as a perception prospective, focusing solely on fundamentals could be detrimental to performance over the long term, and vice versa investing solely on perception could bring in a nasty surprise at a certain point, accounting for both aspects is an essential component for proper portfolio management.