We start off with an observation that may appear self-evident:
- Great investors are not necessarily great businessmen and
- Great businessmen are not necessarily great investors
This has created an interesting paradox. How can different people have such different views on the same subject matter – chiefly the investments in common stocks?
What happens in the business world and what is taught in the vast majority of finance courses is striking different. For example the projecting of future cash flows or the calculation of intrinsic values of business are uncontroversial parts of any business school curriculum.
Approach a businessman with the same set of projections and hilarity ensues.
How can financial analysts proclaim to have precise calculation of business values when management themselves do not know with precision what lies ahead in the coming year? How can two experts in their field arrive at vastly different conditions?
My own observation and hypothesis is that both people are in fact looking at different sides of the same coin. The failure to appreciate the other point of view lies in the entrenched thinking that each possesses the entire tool-kit to analyze the issue at hand.
As Charlie Munger put it poignantly, “To the man with a hammer, everything looks like a nail.”
Let’s take enquiry a step further by engaging in what admittedly is an exercise not steeped in empirical research but my own observation and reasoning. It does not reflect that my own view is necessarily correct, but I hope it reflects the sincerity of my opinion.
As an individual with a legal background, I routinely deal with unquantifiable unknowns and the tool-set which we use to derive a solution involves a heavy use of precedent, observation and deductive reasoning.
Based on current academic research, we can say with a high degree of confidence that the average individual does not engage in reading or learning outside his or her job. The vast majority (or the consensus opinion) is thereby a rough reflection of the existing state of knowledge that is most commonly accepted within that period of time.
It is the nature of higher education that we are pigeon holed into “silos” of academic knowledge. You have accountants, lawyers, manager, financial professionals and so on. When analyzing a business however, the view of each tells a different part of the same story, albeit from a different point of view.
My own observation of courses that are meant to promote holistic thinking are that they are far often treated like a slideshow to the man event. Specialists in their respective field it seems are more richly rewarded than generalists.
There is a large degree of truth to this observation. What practical use is knowledge of history, ancient civilizations, languages and culture on a relative basis compared to the hard skills that lead to immediate financial rewards?
A technician or engineer is first hired not to allocate capital but to solve technical problems at an immediate and practical level. The route that the vast majority of market participants take is therefore quite rational.
The efficient market theorem postulates that the price today on an asset reflects its “correct” value.
Let’s try to dig deeper into what this really means.
Markets are inherently made up to buyers and sellers that are essentially institutions or individuals. The vast majority of these individuals are however untrained for the most part in financial analysis and business management. They represent people from all walks of life. Thus, what the market in essence reflects is what market participants with their own knowledge and experience think the asset is worth as opposed to what the asset value is inherently worth.
Although intrinsic values & perceived value may coverage, there are frequently times they do not.
I realize that I am now approaching on area that seems to have no definite or absolutes. We have left the realm of precision and entered the uncertain world of relatives. How does one measure the value of something if conventional models do not work?
Experience has taught us that to understand how the financial markets work, you need to grasp the fundamentals of human psychology and neuroscience. The field of behavioral economics shows great potential in unlocking these mysteries.
It is well known that different people can have vastly different inspections of the same event. The brain deletes, distorts and outright manipulates what we think we see as opposed to what really happens. However, there must ultimately be only one true account of the incident. In the court it is often the role of judges to piece the most rational and plausible explanation of what happened.
The same is true in investing. Take for example a hort term price decline in the price of a company as a result of an earnings miss. The result in the short term is often a knee-jerk reaction, based upon the experiences of those who are actively buying and selling in that instance.
The motion of a mis-priced, undervalued security provides a logical conundrum. How can a security be mispriced and not be snapped up to its right value? And again how can an overpriced security be overpriced? Can it be said that the markets are truly efficient when the share price of a stock trades at $200 on one day and $0 in the next year? These are some of the questions that we will continue to explore in our subsequent memos.