Fundamentals of Financial Intelligence
The Value of Financial Products
Why Not To Buy Stocks Like Shoes
In economic terms, the reason the stock market differs from the racetrack is that the amount of value the entities underlying it (e.g. stocks) stand to deliver is not fixed. As long as a business continues to operate, it will continue to create wealth. Of course, this is expected and priced in, but businesses can outlive individuals, and when it is given a price the amount of value assessed is fixed, and the business can continue to grow or simply exist. At a racetrack the most you can win is the amount the other gamblers put up before the race began; businesses can continue to adapt or expand to stay afloat. A stock’s price multiple (number of future years’ earnings the present sale price commands) represents some kind of optimistic minimum. The buyer and seller could theoretically both be making good decisions: the seller, perhaps a retiree, wishing for money both guaranteed and upfront, the buyer seeking a greater net amount but willing to absorb both some risk and delay; at the racetrack one party or the other has necessarily made a losing play.
Intelligent investing, however, still depends on intelligent assessment of value. This is tricky because nothing has any “absolute” value. Value is a function of nothing more than how badly people want something, how much of their net resources they are willing to exchange for it, relative to how easily it can be produced or delivered. Many bureaucrats past and present decided they “knew” what things were worth, based either on ideological conviction or undue confidence in their ability to predict people’s desires, but unfortunately for them and their constituents value can only speak for itself. If nobody wants to do a certain job, the rates that workers who do it command will be high. Kubrick could afford to pay his actors relatively little, because he assumed that they put a value on the experience of working for him in excess of the number of dollars they took home. If everybody wants a product of which the supply in the world declines, the price will rise. Its important to note that these are not always linear functions, because the economy of scale (or the means of distribution, itself a form of wealth afforded by prior investment and technology) changes everything. If demand for something is very low, the price might not actually drop, because the mechanisms for creating and distributing the product might decline in turn discontinuously, making it much more expensive to deliver. For example, telegraph delivery is no longer in high demand, and the few people who still do it probably exist more as a novelty item and have much higher fixed costs since the demand for their product is erratic and negligible. Or, if the one factory in the world that makes pocket watches goes under, then they can only be made by hand and will demand a higher price point. The reason for a spike or drop in supply or demand makes no difference, the volume of each are what determine the price at which the market can offer a product. In Mandarin Chinese, which brooks copious homophones, the sound for “four” is the same as the one for “death.” The Chinese are very superstitious, and fourth floor properties consistently command much lower prices than third or fifth floor ones in the same building.
Why does this matter? Well, if you’re in the market for consumer products, it doesn’t. But it matters quite a bit to investors: the price you are expected to pay for future cash flows is determined not just by the masses’ best guess at what those cash flows will be relative to their best guess about the cash flows from all the alternatives — it is also determined by the fads, emotions, and countless other vagaries that assail frail human nature. Now, if you want to buy a cup of coffee, can of cola, or pair of designer shoes for 2–200 times more than the non brand name one that was probably made in the same factory, by all means do so. However, to disregard the “bang for your buck” on a product whose sole purpose is to return you more than you paid for it, is abjectly insane. Fortunately for those willing to heed this principle, many people, if not most, are abjectly insane.
All this is to say, there is a certain “second derivative” value proposition of a stock’s price. Stock prices are determined by no more than the volume of demand for them. But fads can persist only because the calculation of future money to be delivered remains ambiguous — stock market fads depend on the plausibility of an assumption about the future, not simply the tastefulness of holding it. Or perhaps more accurately, the tastefulness of a faddish assumption about the future depends on its continuing to remain plausible. (In)famously, in the late 90s when everyone was anticipating the Internet’s revolution of consumption and destruction of brick and mortar, many stocks soared to colossal heights before turning a dollar of profits, and in some cases, even of revenue. People were more worried of missing an opportunity than of losing money. It was always possible that those stocks would make their early investors billionaires. And it was equally always the case that they were gambles, not investments. Every so often there necessarily emerges another lottery winner; this never makes the lottery a good addition to an investment portofolio on financial grounds. People play it for fun, just like any other form of the gambling which betting on unproven stocks necessarily is. There can be room for speculative investments even in a prudent portfolio, but a company with no track record is a gamble, not an investment with risk. There is no way to assess risk because there is no way to divide by zero.
Examples of a worthwhile speculation could be a (non-public) startup to which you actually have inside access, or a ‘turnaround’ company selling cheaply enough to compensate you for the risk in the event the turnaround pans out. But the point is not even that these were necessarily, ipso facto exceptions, but only that the reason for their sky-high valuations was fad, not financials. Nobody wanted to be the loser who missed the trend that everyone saw on the wall, which combined with the post-Cold War American euphoria that made geopolitical and financial darkness seem like relics of the past.
Moral of the story: trendy consumer products may be worth their inflated price, depending on your taste, but trendy financial products definitionally aren’t. A good stock is not simply that of a good company, but a good company relative to the market’s assessment that it’s a good company. Great companies at high prices and poor companies at low prices are both mediocre investments; the bullseye is always simply a business (or debt, option, etc.) priced somewhat less greatly than it is. It is estimated more money went into the aviation industry than has ever come out of it, but I’m sure every bland cocktail party commentator noted in passing what a great time it was to be in airlines in the 40s and 50s (or automobiles the decade before, or plastics, the one after, etc. etc.) Economic trends mean nothing in themselves, even if correctly assessed; and the easier they are to spot, the more likely the demand to participate in them exceeds the amount of money they stand to deliver.