Michael J. Mauboussin is the director of research at BlueMountain Investment Research. A prolific author and adjunct professor of finance at Columbia Business School, he is one of Wall Street’s most creative and influential minds.
The following observations are from his latest paper – Who is on the other side?
The Question.
If you buy or sell a security and expect an excess return, you should have a good answer to the question “Who is on the other side?” Ideally, you should understand your counterparty’s motivation and ask why you have an edge. So, in effect, you are specifying the source of your advantage, or edge.
Ed Thorp, a mathematician and legendary hedge fund manager, suggests that you have edge when you “can generate excess risk-adjusted returns that can be logically explained in a way that is difficult to rebut.” In other words, you have a good answer to the question “Who is on the other side?”
The Story.
Anticipate how the narrative about a company will change, leading to a revision in the valuation the market accords the stock. The change in a stock price over time reflects a change in expectations. Fundamental results, including sales growth and profits, exert a large influence in shaping expectations. But the stories that investors tell, and believe, also play a meaningful role in revisions of expectations.
Psychologists have shown that “alternative descriptions of the same event often produce systematically different judgments.”
In June 2014, Aswath Damodaran, professor of finance at the Stern School of Business at New York University and a recognized expert in valuation, suggested a valuation for Uber, an online transportation network, of $5.9 billion. His analysis came on the heels of a round of fundraising that valued the company at $17 billion.
The next month, Bill Gurley, a leading venture capitalist at Benchmark Capital, whose firm was an early investor, responded with a piece called “How to Miss By a Mile,” suggesting that Damodaran considered a total addressable market that was too small.
Both are believers in valuing businesses using a discounted cash flow model. At the heart of their disagreement was a description: the professor thought Uber was going after the global taxi and car-service market and the venture capitalist assumed vastly more cases for using Uber, including replacing the need to own a car.
At the end of the day, the value of a company’s stock is the cash it distributes to its shareholders over the company’s life. But a company’s stock price along the way can contribute to the company’s reputation, capacity to raise capital, and ability to pay employees with equity. Damodaran and Gurley agreed on the tools of analysis but differed on the narrative to drive the analysis.
The Timing.
Behavioural inefficiencies can have different time cycles. For example, momentum tends to reverse over a relatively short period of time of less than a year. Large bubbles can take years to burst. A number of prominent value investors, including Julian Robertson at Tiger Management, closed their funds following the dot-com boom in the late 1990s. The main point is that taking advantage of behavioural inefficiencies can take more time than money managers perceive they can afford.
The Sentiment.
Using Graham’s metaphor, Mr. Market is generally reasonable and price is roughly equivalent to value. But Mr. Market is prone to extremes. When sentiment is uniformly positive or negative, be prepared to visit the opposite side of the argument. But being a contrarian for the sake of being a contrarian is a bad idea, and the consensus can be correct.
The Valuation.
When markets go to extremes, valuations tend to follow. The crucial question is, “What expectations for future financial results are implied by the current price?” When sentiment shifts are excessive, expectations become unduly high or low. Do the math. Figure out what you have to believe to justify the prevailing price, and compare that to plausible scenarios.
The Facts.
When an asset price is under the spell of extreme sentiment, make an effort to explicitly separate facts from opinions. A fact is information that is presumed to have objective reality and therefore can be disproved. An opinion is a belief that is more than an impression but does not meet the standard of positive knowledge. As a result, an opinion may be difficult to disprove. Both facts and opinions are useful for investors, but facts should rule the day.
The Reaction.
Phil Tetlock, a professor of psychology at the University of Pennsylvania, raises some other common mistakes. One mistake is overreacting to information that superficially appears to explain causality but in fact does not.
For example, in the analysis of merger and acquisition (M&A) deals, some equity analysts sometimes upgrade a stock following the announcement of an acquisition as the result of anticipated earnings accretion, only to see the stock drop. A change in earnings is not the best way to capture causality in M&A. Overreaction to new information can also be the result of the contrast effect. The idea is that good news is perceived as more impressive than it should be if it is preceded by bad news, and less impressive than it should be if it follows good news. These are errors in perception that lead to mispricing, and a strategy to capture the contrast effect appears to generate excess returns.
Another mistake is for the decision maker to underreact to information that he or she fails to recognize as causal. Continuing with the theme of M&A, meaningful but underappreciated information includes a comparison of the present value of synergies with the premium pledged. This requires some modest calculations but is demonstrably more relevant than earnings changes based on accounting figures. Decision makers who are able to distinguish between what information matters and what doesn’t have an analytical edge.
The Conviction.
Benjamin Graham offered what might be the best advice. He said, “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ. (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.)”
