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Random Talk by Vishal Gupta Life is meant to be a random walk – my life has always been one. Through the Random Talk blog I share my experiences and perspectives on life as I perceive it. You’ll find here some original (non-mainstream) thoughts on various random topics that interest me – life,... More
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  • Money Money Money (Part II): Rules - The Essential Principles Of Investing 0 comments
    Nov 12, 2013 11:37 AM | about stocks: TWTR, SVVC, KORS

    From the Random Talk blog: http://vish4life.wordpress.com/

    This blog post is the second of a 3-part money trilogy:

    Part 1 - Themes: How to build an investment portfolio based on major themes of the moment to make it "trendy" (pun intended)

    Part 2 - Rules: Some basic tenets to test your investment ideas and make them work

    Part 3 - Styles: Selecting an investment style consistent with your personality

    Let me start by saying a big thank you to the readers of my blog for your overwhelmingly positive feedback and comments you have sent me on the first part of this money trilogy - I am glad that so many of you have taken kindly to the idea of theme-based investing. Apologies, I decided to delay the second part of this trilogy to allow the Twitter IPO to complete enabling me to draw some fascinating insights for the purpose of this blog - some of the price action, as I argue below, turns a lot of conventional market theories on their heads. Those of you who follow me on the social networks would have also noted that my long held prognosis of a 50% plus pop on day 1 of trading in Twitter came true. I had also put out a day 1 closing price target of $50/ share, which turned out to be the intraday high, and we closed five bucks shy off that. I have also been arguing that the stock could come under selling pressure in the coming days as the IPO frenzy abates as does the status symbol value of owning Twitter stock, now that every man and his dog can buy it, and sell it - a far cry from its days of being much the prize investment that Al Gore tried (unsuccessfully) to court by treating the founders to "copious amounts of tequila", and one Ashton Kutcher allegedly had a bikini-clad Demi Moore as a prop during a poolside overture to get a piece of the pie! However, I do stick to my long term call that $TWTR would, in time, join the 100 billion dollar club (market cap).

    Lady in Red

    Talking about IPOs, let me briefly digress into another news story that caught my fancy this past week - this was about fashion retailer Michael Kors ($KORS) becoming the latest member of the coveted S&P 500 index, two years after its IPO, which ironically was not as fashionable as Twitter's IPO! The story reminded me about a few events. It was the summer of 2012, and my wonderful sister (by far the smarter one out of us two siblings) was just completing her Masters from an elite B-school in the US and had invited (or ordered) me to attend her convocation. As part of my brotherly duties at her convocation, I offered to buy her a gift of her choice, any gift. Her response was prompt - she wanted a watch, not just any watch, a Michael Kors watch - it was a practical, yet stylish gift - that's my sister for you! That would have been that, except that as I spent the next few days on her campus, and got talking to few of her friends, it soon dawned on me that a Michael Kors gift - watch, handbag, or jewellery - was on the wish list of almost every girl - especially the trendier looking ones. Curiously, noone wanted Coach - which, with my limited understanding of women's fashion in America, I had considered to be the most popular brand in the affordable luxury segment at the time. A few days later, back in London, I was on a bus with my wife, on our way back from one of her customary shopping trips to the west end, when an extremely attractive young lady got on to the bus - looking rather chic in a stylish red dress, and just as she sat down on the seat opposite us, I spotted the distinctive MK signage on her handbag. Emboldened by my recent trip to the US, where it is completely acceptable, even polite, to strike a conversation with a stranger on public transport, I passed her a compliment making sure to mention the handbag. Much to my relief, she responded with an American-ish openness - it turned out that she had just acquired the bag from the recently opened London store of Michael Kors. She went on talk about how a lot of women in Europe tended to settle for nothing less than a Louis Vuitton or Birkin bag, but (pointing to her newest accessory) she finds this just as trendy at a much more practical price point. My wife did give me a piece of her mind when we got back home, but that was a small price to pay for a bit of invaluable market research. These two independent observations, one in the US, one in London, spurred me to explore Michael Kors further - amongst others, I found that Michael Kors had just become the most searched fashion brand online, and the @michaelkors handle had one of the highest Klout scores on Twitter (now, you could see a Twitter connection coming, didn't you?). Michael Kors was leading a trend shift in affordable luxury in the US, and was also taking the trend to Europe. The reason for narrating this story is to illustrate an example of what I meant when I said in Part 1 of this trilogy that winning investment ideas are often found by observing trends around you. $KORS stock has risen four-fold in the past two years. Coach ($COH), by the way, is down a third!

    Hypotheses, Empirics & Laws

    The main focus of this, the second part of the money trilogy is Rules - here I try to develop a framework of a few "truisms" that govern modern markets, and derive from them some practical rules to traverse the vagaries of the market successfully. Now, since I am writing a money trilogy, it is too tempting to not use this opportunity to propose my own theory of what drives markets - everyone agrees that noone actually knows the answer to that, and yet some people get given a Nobel prize for proposing an explanation. So, this is my one shot at the Nobel! It is generally accepted convention that any serious Nobel aspirant demonstrate that they have researched the existing body of knowledge and their work is an advancement on that. So, I hereby declare that I have duly studied the works of two of the most recent Nobel laureates - Messrs Fama and Shiller. I also note that one of these men describes his work as a "hypothesis" on efficient markets, and the other provides "empirical research" on the inefficiency thereof. This, I believe to be an acknowledgement that the field of finance and economics has yet to find the intrinsic "laws" defining its structure - a stark contrast from physics, for instance, where the defining theories have been cast in the form of laws, mostly attributable to one Isaac Newton. Finally, it is also societal convention that the theory carry the last name of the proponent. So, below, I present what we shall call "Gupta's Laws of Modern Market Motion" or the "M3 laws". Just in case any members of the Nobel award committee happen to read this, I wish to stress the point that I am putting forward laws - the intrinsic defining principles - not just hypotheses or empirical evidence; hence, these must be taken with at least as much seriousness as someone proposing a law based on the chance falling of an apple on one's head.

    Gupta's Laws of Modern Market Motion

    **** Gupta's 1st Law - Non-uniformity ****

    Statement of Law: Financial markets are non-uniform, as participants have differing levels of access to different markets. The collective interpretation of those that have access to a given market at a given time determines the level of prices in that market.

    Corollary 1a: It is entirely plausible, and indeed is to be expected, that the price of a security in one market will be different from the price of the same security in another market provided that not all participants have the same level of access to both markets.

    Corollary 1b: When the level of access to a market changes, such that new participants are allowed or denied participation in the given market, for the same level of current and future information available, the collective interpretation of that information changes, and will have an impact on the level of prices.

    Evidence & Everyday Applications: IPOs are a great example of Gupta's 1st law in action, as when a company moves from trading in the private to public market, the set of participants who have access to investing in it also changes. This explains why certain securities jump in price on listing (public markets view it more favourably) or certain IPOs fail to perform (public markets view it less favourably). Of course, modern marketplaces are complex and, at a given time, there may be several markets in which a security may be traded directly or indirectly. So, in relation to the Twitter IPO, there are multiple markets worth analysing: 1) The pre-IPO venture capital market 2) The institutional IPO market that had access to buy Twitter at the IPO price 3) The grey market run by various spreadbetting platforms representing, not thousands, yet a critical mass of hundreds of investors who took a position on $TWTR price prior to the IPO. 4) Listed vehicles such as $GSVC and $SVVC that have in the past several months traded as proxy investment in $TWTR 5) Various structured securities issued by banks/ brokerages linked to $TWTR price 6) the actual public exchange where $TWTR is now traded. All these markets were trading the same underlying security whose value is predicated largely on a vision for the future (resulting in information equity), and yet the marked variation in price development is explained by the different levels of market access and how the different investor segments had a different collective interpretation of the same available information; and indeed, tried to guess the collective interpretation of those operating in another segment of the market. Prior to the IPO, the last available pricing benchmark for Twitter's price was the private venture capital market which had valued it at c. $20/share in February 2013 (in the subsequent months, the whole social media sector underwent a massive re-rating, which should have translated into a significant increase in valuation of Twitter). Of particular interest is the price disparity between the institutional IPO market and the pre-IPO grey market. It is, and was, well-know that the IPO process was going to be super-exclusive, and in the end only about 100-odd chosen accounts were given an allocation at the $26/share IPO price. Others (non-US citizens), who believed the post-IPO pop story, had the ability to buy in the grey market, where trading commenced more than a month before the actual IPO at an implied price of $20/share, which remarkably also turned out to be the first official IPO price guidance a few weeks later. However, by that time, the grey market had reached critical mass, and the price had ratcheted up quickly. I am given to believe that the average purchase price for anyone who acquired a meaningful stake in the grey market was $35-40/share, higher than the IPO price of $26/share, but lower than the day 1listing price on the public market of $45/share. Equally interesting, the listed vehicles (the best publicly traded Twitter proxy available to US investors), $GSVC and $SVVC got bid up in the run-up to the Twitter IPO, trading at an implied $TWTR valuation of $45-50/share immediately before the IPO pricing, but then crashed as soon as $TWTR became available to these investors. Finally, I am told that various structured notes linked to $TWTR price had a strike price of $35/share. So, as these multiple markets were trading the same underlying security at the same time at a different price, it clearly shows that markets are non-uniform and the difference in price was on account of different levels of market access and the differing collective interpretation of the available information at the time. Q.E.D.!

    **** Gupta's 2nd Law - Conservation of History ****

    Statement of Law: The collective expectation of participants in a market for historical events to repeat is inversely proportional to the length of time that has elapsed since the occurrence of the event

    Corollary 2a: The memory of a recent related event will lead to price discontinuity (jump) as the participants first prepare for a repeat of the event, and then re-adjust their expectations when the event fails to re-occur

    Corollary 2b: The memory of a distant related event will have a diminishing influence on market prices as participants apply an ever-decreasing probability of recurrence ultimately resulting in over/under-valuation and manifesting in asset price bubbles and crashes [As this corollary explains the occurrence of bubbles, I propose that it be referred to as the "bubble corollary"]

    Evidence & Everyday Applications: Gupta's 2nd law implies that expected market price action is conditioned by historical events, and market participants (erroneously) apply the highest weight to the most recent relevant event. No wonder then, that in the run up to the Twitter IPO, reams of newsprint were devoted to how Facebook's share price tanked after its IPO - so much was the hysteria, that it may actually explain why Twitter eventually priced the IPO so much lower than where it first traded. There was no reason why the $FB IPO should have been used as the benchmark for expectations. There had been several internet IPOs before that which delivered a significant day 1 pop - LinkedIn (109%), Yandex (55%), Google (18%) - in fact, Facebook was the only notable exception. Yet, the disproportionate focus on $FB's IPO flop show can only be explained by the fact that it was the most recent example. Of course, it was wishful thinking to expect that $TWTR would crash below IPO price once trading commenced, which explains the 76% jump, as the expectation of a repeat failed to materialise. Of course, Twitter now takes over as the most recent example, which has encouraged many analysts to argue that now is the best time for any and every internet company to IPO - nothing can be further from the truth, as even though we are in a part of the economic cycle supportive of IPOs, but few other companies have quite the unique business model as Twitter does. It would be fallacious to use a utility like Twitter as the benchmark for the IPO prospects of other internet companies. Yet, there is every chance we are headed in a direction where too many companies with unproven business models become listed, first leading to a valuation spiral (I do not agree with those who claim that we are already in bubble territory), and then the inevitable crash circa the 1990s tech boom-bust. It is also important that when there is an asset price bubble, it is not that the price of everything has become ludicrous - the price of "game-changers" like Amazon ($AMZN) and Ebay ($EBAY) during the 1990s tech bubble surely looks like a bargain compared to where they trade today - they were still good investments during the tech bubble - when we say, there was a bubble in tech stocks, it is important to remember that we are referring to all the other chaff that also got bid up. I agree with the possibility, even the inevitability, of the valuation of internet and social media stocks reaching bubble territory; but, that does not necessarily mean that "game-changing" market leaders like $TWTR and $FB are part of the bubble - the bubble, in fact, would be in companies and investors unwittingly trying to ride the $TWTR/ $FB wave elsewhere. It is the rooting of expectations for the next market movement to the most recent event, which leads to valuation spirals and the boom-bust cycle. Q.E.D.!

    **** Gupta's 3rd Law - Action-Reaction ****

    Statement of Law: For every action (new information entering the market), there is a reaction (change in price), not necessary equal in magnitude or direction to the long term impact of the action

    Corollary 3a: Markets are temporally efficient in absorbing information, and market prices respond immediately to any new information becoming available [note that this corollary provides confirmation for Fama's efficient market hypothesis, I therefore propose that it be referred to as the "Fama-Gupta corollary"]

    Corollary 3b: Markets over-react to information, and with the passage of time, this over-reaction will correct itself [note that this corollary corresponds directly with Shiller's central argument that price changes following earnings surprises are not commensurate with future changes in the level of dividends, I therefore propose that it be referred to as the "Shiller-Gupta corollary"]

    Evidence & Everyday Applications: Gupta's 3rd law explains how market prices respond to new information entering the market, and in effect provides reconciliation to the apparent contradiction of the Fama and Shiller views of the market. The law provides that, as argued by Fama, any new information gets reflected in the market price action immediately. However, the law allows for the failure of market participants to interpret the information correctly, thus accommodating Shiller's argument of over-reaction. In fact, at the extreme, the law indicates that the price action may actually be in a direction opposite to what the information indicated. This is verified by the price action in the various markets for Twitter stock (refer discussion under 1st law), in response to new information. It is significant to note that even though Twitter was trading at a different implied value in these different markets in the lead up to the IPO, as soon as new information was made available, the price in all markets moved, in a different degree and direction. So, when Twitter released the initial price guidance of $17-20/share (which should have been relevant only for the handful of institutions who had a shot at getting an allocation at the actual IPO price), there was a price adjustment in the other markets. By that stage, the grey market had already undergone the price discovery process and was trading in a $45-50/share range (which was the eventual day 1 trading range on the public market), yet the release of this new information disturbed the equilibrium in that market with the price immediately crashing to $25/share, before undoing the exaggerated correction over the next few days. The listed proxy vehicles, $GSVC and $SVVC, experienced a more muted price drop. Every subsequent revision of the price guidance produced a similar price discontinuity and then retracement back to the level before the news release. $GSVC and $SVVC eventually settled to a level that implied that investors expected the $TWTR holding in their portfolio to be worth $45-50/share. When $TWTR actually commenced trading at $45/share, instead of the price remaining unchanged, their stock prices actually nose-dived - the price reaction was in a direction opposite to what the news action implied. This is, of course, explained by Gupta's 1st law which does provide for market prices being impacted by a change in the level of market access - the investors in $GSVC and $SVVC could suddenly buy $TWTR directly, and as soon as $TWTR started trading they instantaneous exited the market en masse, hence the crash. Markets react instantaneously to new information, and yet the reaction does not have to be commensurate in size or direction implied by the action. In other words, markets are informationally efficient, but not price efficient. Q.E.D.!

    Rules - Stupidity, Humility, Passivity

    Ok, so that completes my theoretical framework for what drives markets. As I mentioned in Part 1 of this trilogy, I am particularly keen to ensure that any financial talk be actionable in nature. So, in the final section of this post, I put forward a few simple rules for you to use as a practical guide in traversing the markets successfully, and happily! In putting forward these practical rules, I draw upon both the theoretical laws I have explained above, and also what I have learned from years of practice.

    Rule #1: Stupidity

    ++++ Be stupid first, then lucky ++++

    I once attended a speech by a leading global property investor. One of things that stuck with me from that speech was - "Successful people think differently". It must be the case - In order to outperform the market, the successful investor has to think differently from the rest - his views therefore do not comply with the popular opinion. To test my investment ideas, I have, over the years, developed what I call the stupidity test. This is how it works - when you have an investment idea, casually drop that into conversation at a social gathering. If the idea is at odds with the popular opinion, which is generally rooted to the most recent relevant event (as per Gupta's 2nd law of Modern Market Motion), people are generally only too keen describe it as stupid. The more stupid people find your idea, the greater the chances you are on to something. Of course, this doesn't mean you randomly throw out ideas at parties - this works only when your investment idea is borne out of strong conviction and you have a clear investment thesis yourself. Over a period of time, you may also try out the second step of this process, and tell people about how one of your non-mainstream investments had worked, to which you are likely to get the response - "you were just lucky, mate!" I'd take that - the purpose of investing is to make money, not to become popular - ok, granted, if you're Warren Buffet, you can do both!

    ++++ Being average is better than being the smartest +++

    Here's two numbers for you to consider - 95% and 7%. The first, 95%, is a number which a financial adviser once gave me when I asked - "what proportion of people lost money in the equity market?" The second, 7% is the well-documented "average" real return from investing in equities over the last 100 years or so. So, if on average, the markets are generating a return of +7%, how come 95% are losing money? The answer lies in people trying to be smarter than the market and in the process getting trapped by Gupta's 2nd and 3rd laws - conservation of history, and action-reaction. The financial markets are not school where you vied for the top grade, here it is Mr. or Ms. Average that are the winners!

    Rule #2: Humility

    ++++ Could I, not should I +++++

    As Gupta's 1st law suggests, markets are non-uniform, and market access determines the price you pay to acquire an asset. So, when you are analysing an investment opportunity, as important as asking should you invest, is to ask whether you can. And then ask, why you can - if you can just because everyone else can as well, then ask why your thesis is different from the collective thesis of the rest of the market at that time. Again, referring to the Twitter IPO, there was a lot of hype and discussion about whether one should invest in the IPO - this was a futile discussion for everyone other than the 100-odd institutions that got an allocation in the IPO. So, why was the rest of the world debating this? And the institutions that could get an allocation, actually didn't even need to consider whether they should - they just vied to get as much as they could - no wonder, the IPO was 30x oversubscribed!

    ++++If you don't get it, you don't get it++++

    As market participants give undue importance to recent events (Gupta's 2nd law) and react incorrectly to information (Gupta's 3rd law), you might as well not have the information - ignorance is better than knowledge. Also, if you don't understand a particular market, just admit you don't get it and stay away. During the Twitter IPO process, I listened to a lot of analysts trying to fit Twitter into their valuation models - needless to say, if you needed a valuation model to value Twitter, you were in the wrong market - better stick to stocks with mature business models - those are the ones that can be and should be analysed using valuation models. Only play in the field that you know - winning home games is easier than winning away games, isn't it?

    Rule #3: Passivity

    ++++ The tortoise still beats the hare ++++

    This should be obvious, but if you want to make a quick buck, try the casino or lotto. Investing is the process of building your wealth over a period of several years. Unless, you have exclusive access to a market, like the few institutions that were allocated shares in the Twitter IPO, you can't make supernormal returns in the short term. Like the tortoise, you must keep treading patiently and accumulate wealth drop-by-drop. And if you hang in there, a couple of times during your investing life, you may even benefit from the windfall of changing market access or a market discontinuity.

    ++++ Sit tight when the bulls and bears fight ++++

    Gupta's 3rd law (action-reaction) suggests that markets react to every action. But, every time the markets react, you don't have to act. Investments that do well in the long run, are those which you had a strong conviction for, and so act only when your conviction changes. By all means, revisit your convictions from time-to-time, but don't change the conviction every time a new piece of information comes around. A leading British comedian may have summed this aptly during one of his shows at the height of the financial crisis. "What are all those families who have their houses trapped in negative equity supposed to do?" he asked angrily in a voice capturing the uproarious media sensationalism of the time, and then replied in a coy voice "they could just live in them!" That's what you do with your investment portfolio when the markets are not doing well, as they sometimes will - "keep it!"

    Money Money Money

    So, that brings me the end of the second part of my Money trilogy - Rules. In the first part I demonstrated, using a theme-based framework, you didn't have to be an expert to invest successfully. Here, I have shown that you don't have to be exceptionally smart or intelligent - the only qualities you need are - stupidity, humility, and passivity - and hopefully, all of us can find a bit of that inside us. Ok, the alpha folks amongst you may have to try a bit harder, but you're always up for a challenge anyway!

    How did you find this blog post? I would love to hear. In the next and final part of this Money trilogy, Styles, I will talk about the link between personality and investing. Keep reading Random Talk!!!

    Disclosure: I am long TWTR, GSVC, SVVC.

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