Pee Dee's  Instablog

Over the last few years, there have been a number of popular books that encourage being a follower.  These have ranged from following one's gut instincts (Gladwell's "Blink") to a theory overturning what your mother told you about your friends' proclivities to spontaneously go cliff diving (Surowiecki's "The Wisdom of Crowds").

These books mark an interesting contrast after decades of business books on how to be a leader and the adoption of this discipline in US universities.  What's interesting is that these books on “following” continue to have influence even after the blood bath of mass real estate speculation around the world leading to the dismay of many participants and the economic funk that exists today.

The Chinese Emperor’s Nose

We'll draw some insights from a passage from Richard Feynman, physicist, iconoclast and one of the most pragmatic academicians and scholars during the 20^th century.  He wrote an unforgettable passage in one of his autobiographies, Surely You’re Joking Mr. Feyman:

“This question of trying to figure out whether a book is good or bad by [either] looking at it carefully or by taking the reports of a lot of people who looked at it carelessly is like this famous old problem:  Nobody was permitted to see the Emperor of China, and the question was, What is the length of the Emperor of China's nose? To find out, you go all over the country asking people what they think the length of the Emperor of China's nose is, and you average it. And that would be very "accurate" because you averaged so many people. But it's no way to find anything out; when you have a very wide range of people who contribute without looking carefully at it, you don't improve your knowledge of the situation by averaging.”

 

What can a theoretical physicist teach us about investments?  No; not that we need more Greek letters in financial formulae.  Rather, if we substitute “investment” for “book” in the passage, we get a novel view of investment practice.

Cheating vs. Efficiency

Contrary to what most understand about Wall Street and its sell-side prognosticators on matters such as EPS, long-term growth rates and even GDP estimates, a very small handful of people set the mark for others to follow and emulate.

It usually starts with a company’s senior managers or a nation’s finance minister making public or private proclamations of next year’s bounty.  These figures are sometimes constructed with the help of the analysts themselves.  Here’s an example of a fictional, private exchange between an analyst and a company’s managers during a phone call:

Analyst 1:  Hey CEO / CFO, this is Analyst 1 calling to ask about your thoughts on the top line for next year.  Any guidance?

CEO / CFO:  We think next year we could organically grow top line at 15%.

Analyst 1:  Huh, that’s interesting.

CEO / CFO:  What do you mean?

Analyst 1:  Well, everyone seems to agree that the industry is flatlining at 10% a year.

CEO / CFO:  Well, we’re better poised to take advantage of growth opportunities.

Analyst 1:  I see.  I spoke to the competition accounting for 90% of industry revenues and they're expecting about 13% growth.  Which comps are you taking market share from?

CEO / CFO:  Look, we’re better set to take some share from them all.  We have a better team and better products.  What have you got us growing at next year?

Analyst 1:  Considering this mature industry’s demand is growing at 10% and others are spending heavy to get their targeted 13% growth that could lead to price cuts, I’ve got you down at 12%.

CEO / CFO:  What about the comps?

Analyst 1:  We think they’ll do about 10% give or take 100 or 200 basis points.

A few weeks later comes the company press release:

CEO / CFO:  “We expect to lead the industry with 12% growth this fiscal year.”

Whether this fictional exchange violates Reg FD is neither here nor there.  The point is that there’s a feedback loop in the mechanism.  But the story continues at a watering hole in the financial district…

Analyst 2:  I was waiting for Analyst 1 to come out with his estimates for this company.  Did you see that he has a lower rev estimate?

Analyst 3:  Yeah, I saw.  He knows the firm really well and is friendly with the top.  His corporate finance guys also lead all their securities issuance.  He must know something.

Analyst 2:  He definitely knows something since we had the name growing at 15% for next year’s top line.

Analyst 3:  I’m taking my number down to 12.5%.

Analyst 2:  I’m putting it at 12.75%.

 

This isn’t always the case but it’s more than often how the story goes.  Before the setbacks for investment banks’ research departments since 2000, there were perhaps three or more dozens of analysts with estimates for the largest US companies.  As we know, in any given schoolroom, there will always be half the classroom falling below the average of their peers—it’s a given.  And looking at the neighbor’s quiz during the test?  In school that’s “cheating” but on the job that's “efficiency”.  It’s safe to say that financial analysts don’t all do proper analysis and diligent forecasts—even if they all tried and were competent at either.

“Uninterested Persons”

This phenomenon does not account for interests of certain parties.  No; this is not about analysts acting as shills for their underwriting departments.  Any media outlet worth its salt operates not dissimilar to a politician seeking reelection—everyday—where constituents vote with their time and wallets.  For example, plagiarisms, fabrications or a discovered neon "For Sale" sign hanging above the newsroom or congressman's forehead often lead to fewer votes.  A good sensational investment story, especially in a bull market, is better than a dry page of numbers and dull facts.  The more extraordinary, strange, provocative, exotic, "exclusive" or bizarre the story, the better for increased readership.  One Australia-founded, global media company has become a juggernaut on this premise alone.  Uninterested persons promoting or featuring investments are as rare as sighted unicorns.  It's one reason this blog poster does not make specific investment recommendations.

How do We Make Money From This as Investors?

“Okay, so I know that financial analysts follow the herd and that media companies play along.  All this platitude is interesting but trivial to my pockets.  How do I make money from this?” someone asks.  Capital flows not to its necessarily best use, as economists like to say, but to what gets promoted best.  The trick for an investor (not a leveraged trader) is to note what is being promoted in the daily, weekly and monthly papers and look for the other areas that are being overlooked or, even better, maligned because of the current zeitgeist of hype.  The analogy of a seesaw works here where the capital piling on one side will get lower future returns while the other side has better prospects.  At any given time, there is after all a finite, though constantly inflating, sum of capital available amongst investors.

For example, during the dot-com boom, some of the greatest and / or largest growing US companies were available at single-digit PE multiples of trailing earnings.  Hardly anyone was interested ten years ago in food processor Archer Daniels Midland Company, then selling for less than 10x earnings while it was developing ethanol processing plants.  Today, its CEO is a former senior manager of Chevron Corp. and the stock has more than tripled in addition to cash dividends earned.  This was all despite a company with a history of poor governance and management.  Those returns even pale in comparison to that of then-better managed competitor Bunge Ltd., whose IPO in the “super-sexy” food processing business was completed in the midst of 2001’s recession and a Nasdaq apocalypse led to its pricing meaningfully below Bunge Ltd.’s book value.  Today, however, agriculture, ethanol, nutraceuticals and other marketing buzzwords are the type of hype to avoid.  We’ve seen this film before in the ‘70s and we know how the story ends.

Finding Opportunities Today

So where are the opportunities now?  For a common stock investor (again, not a trader), they’re less likely in emerging markets at large (see my earlier posts “Emerging Markets? No, Thank You!” Part 1, Part 2, Part 3 and Part 4).  Nor are they likely in companies undergoing almost certain death (Blockbuster, Inc.).

This is not about being contrarian to the “wisdom of crowds” but about being thoughtful.

Instead, look for common stocks  of a company or companies representative of their industries that are hitting the new lows lists almost weekly; those where they and their competitors struggle to raise any kind of financing despite having viable plans and productive businesses; those undergoing a change away from weak strategies or from poor leadership but where such viable change is not widely broadcast, not understood or will take a time period to complete that is outside of most investors’ time horizons of 12 months or fewer.  For short-sellers and simialr speculators as well as opportunistic corporate issuers such as venture capital promoters, there will exist opportunities to take advantage of some sitting on the popular side of the seesaw.  That, however, is beyond this blog post.

Last, it may be helpful to read one or more of those books promoting “follower” principles (this blog poster has read one of those mentioned herein) but keeping a critical point of view while doing so.  While their ideas seem to work for popularity contests such as elections and even for estimating the weight of cattle, they’re not likely to help investors deal with the uncertainties of investments.