Cherished Fortune

Make Your Wealth Your Business

Andrew Allentuck, Benoit Poliquin

• Publisher: Dundurn Press
• Year: 2018
• ISBN:
  9781459742420
• Topic: Desarrollo personal
• Subtopic: Finanzas personales

How new investors can start using a small-business mindset to maximize their wealth. An early start in investing can be a huge advantage, but investors must quickly learn to make the most of opportunities. Thinking like a small-business owner can yield great benefits to investors' portfolios. Running a small business means selling goods you know inside and out to customers you know equally well: what they like, what they buy, what they reject. Using a similar mindset, novice investors can manage their portfolios by understanding what works, controlling risk, and building knowledge. It's about knowing the details of what is in their portfolio and how each stock, and the company behind it, operates. Columnist Andrew Allentuck and financial planner Benoit Poliquin give new investors a much-needed introduction to the critical skills that will maximize their investments' values over their lifetimes.

CHAPTER 1

Crowds: There Is Wisdom in Collective Judgment, but Tragedy Lurks

In some arcane fields of economics and political science, in the concept of having a jury decide the fate of an accused, and in statistical sampling of opinions, the idea that many players can reach the right decision by consensus gets a lot of respect. It is quite different in the relatively mundane arena of trading assets for profit. Often, where crowds go, the individual should not.

To be on the ground floor of a stock before it soars is good. And to be first to sell before it plummets is terrific, for selling is usually harder than buying. The problem for almost every investor is that what the crowd does influences your buy or sell decision. If the stock is going up, that is a buy signal for those who see hope. When the stock price is falling, some will figure that the asset is on sale — a time to buy. The impetus to sell on price movements is the opposite of buying fruit at the supermarket. When the price of apples falls, you may want to buy more; when the price rises, you may buy less. But here the connection to stocks and other assets breaks. After all — and this is the crucial point — you are unlikely to try to resell your apples. Fruit is a one-way decision, unlike stocks, which have an implicit sell concept every time you buy and even a repurchase notion when you sell.

The problem for almost every investor is that what the crowd does influences your buy or sell decision.

We don’t make investment buy or sell decisions independently of the market. Even so-called quants, the managers and investors who juggle numerous variables on their computers to make trading decisions, have to take notice of what others are doing. When the others are part of a stock heading from nothing to the heavens, many observe, want to join the party for fear of being left out, and become part of the problem that, good or bad, assets can become bubbles. And when bubbles are pricked, the path to safety can lead to the abyss of loss.

The irrationality of chasing bubbles is clear in the mirror of a small store owner’s inventory management. If an owner of a dress shop sees a competitor down the block selling out of a certain kind of garment, would it be wise to order as many as possible of it so that they could flood the street with more of the same? Doubtful. Dresses have styles and styles have their day, and one competitor’s stock of frocks isn’t tradeable information. Basing your own buy or sell decisions on the trend rather than the substance is the foundation of bubble madness.

BUBBLES AND CROWDS

The difference between a singularly individual decision and a rush to trade because others are doing it is the problem of crowdthink. In investment markets — the crowd, that is, the mass of investors — by definition stays with the trend. The crowd embraces the wisdom of the moment or, if you like, the convictions of the moment. But trading with the crowd really requires timing. It amounts to trying to time a popularity contest. Errors in underpricing a stock or bond, real estate parcel, or other asset can persist as long as those errors overpricing the same asset. In short, you can observe a bubble or even a trend you think is wrong. The right thing to do is to either trade the other way or ignore what you think is foolishness. Chasing the rainbow is not a good option. Understanding it is quite another matter.

If you dismiss the stock market as collective paranoia, you miss its greatest virtue — over time, with diversified investments, it pays a very nice return. For the very long period from 1802 to 2002, U.S. stocks produced an average annual return of 6.6 percent, almost twice the 3.6 percent average annual return of bonds in the same period. Gold had an average annual return of 0.7 percent over those two centuries. Cash suffered a 1.4 percent average annual inflation-driven loss of buying power in the period.¹ The market cannot exist without a range of estimates of value from dour to wildly enthusiastic, but the investor has to find a path through the emotional chaff to get to the wheat. Clearly, holding for the long run is worth it.

If you dismiss the stock market as collective paranoia, you miss its greatest virtue — over time, with diversified investments, it pays a very nice return.

Crowds drive stocks. Every major company on an exchange has thousands of holders, and very big stocks have tens of thousands. Emotion drives much stock trading activity whether the assets are dullards or demons. The investor can use tools to judge the level of enthusiasm — trading volume, for example — but it is essential to trade against the crowd, not with it. That is the simple wisdom of buying low when others don’t covet a stock, and selling high when they do. Put another way, the market lives on liquidity, and crowds provide that liquidity. For the investor, who is part of liquidity, survival requires reason, as well as enthusiasm, to get into a stock and a strong sense of when the crowd has gone too far in its enthusiasm or despair. The moral: Watch the crowd, but don’t be part of it. In stock investing, independence not only pays, but is also a safety switch.

Herd instinct or groupthink identifies the tendency of people to follow trends. It is a wish to belong, to be part of the movement that is being either smart to get in or smart to get out. It is the pressure to conform or to belong or to be part of what is happening. When these pressures supplant the investor’s own thinking or what should be his or her analysis of a potential investment or sale, then the imbalance grows, with emotion replacing reason. It sounds very theoretical, but it has happened in the past — the dot-coms of the late 1990s, for example — and it is happening as this chapter is being written. The price-to-earnings ratios of such digital darlings as Netflix Inc., which is at 234, and Amazon.com Inc., at 254, are measures of frenzy, not foundations for stable growth. Each stock may reward its holders handsomely if its profits rise to the occasion. It can happen and perhaps will, but for Netflix, for example, to fall to a p/e of, say, twenty would require that earnings rise by 1,000 percent while the share price does not budge. Neither process is likely. Investors in Netflix or Amazon may be handsomely rewarded for their patience or bravery, but the odds are that each company’s exceptional growth will subside and that late entrants will suffer losses. That is the price of late arrival to a fad.

The mechanism of crowd enthusiasm has been called the bandwagon effect. As the stock’s price rises, the shares go from being classed as value investments with p/e ratios of six or so to perhaps twenty, to growth investments with p/e ratios up to forty, and then momentum shares with p/e valuations up to the hundreds. Investors dream of getting in when p/e’s are low and getting out when they are high. The problem, of course, is finding where the party starts and knowing when it is prudent to leave.

It isn’t easy to quit the game when the talk around the water cooler or in the coffee shop is about how, this time, it will be different. It isn’t different, though. Small upstream oil drillers with stocks that seem to rocket off single-digit price bases just as readily fall. Example: Global upstream oil and gas companies slashed expenditures by 40 percent between 2014 and 2016 and laid off 400,000 workers.²

These survival moves may have protected future profitability, but the layoffs made the companies smaller and many of their stocks worth less. Investors abandoned shares of such firms as Baytex Energy Corp., which traded at almost $50 in mid-2014 and subsequently fell to $4.29 in June 2018. The company’s earnings have shriveled, and the stock at today’s price is a bargain if oil prices rise substantially. So far, investors are not taking the bet. Contrarian sentiment is absent.

It works both ways. There is a fundamental social urge to want to join a party, to be part of a movement, or to get in on something others have. The more a stock’s price rises, the greater the pressure to join. If the stock’s price rises high enough, as shown by Amazon.com Inc.’s trailing p/e of 270, the pressure to get into the miracle can be irresistible. No matter that Amazon has no dividends; it was a mere US$400 at the start of 2015. As this chapter is being written, Amazon’s price is US$1,681. It could go higher, of course, and Amazon appears to be eating the retail world. However, with this p/e, if earnings — just US$4 per share — were to drop by one dollar, the effect would be to drive the price of the stock down by US$270. The risk of going in at this valuation is apparent. Yet daily volume in Amazon is 1.3 million shares. Some holders are selling, of course, but for every share sold, there is a buyer. For now, there seems no limit to how high Amazon shares can rise.

The divide between good investments and disasters waiting to happen is the quality of decision making.

One day, it will change. Amazon is, after all, just a phase of retailing. There were bricks and mortar department stores before Amazon, and then combo stores called “clicks and mortar,” which covered traditional retailers that also sell online. For non-physical services, the web is the ideal platform. The limits on sales are conceptual, not physical, but even concepts have their day. It is perhaps too soon to know how far virtual stores can go selling virtual products. It is good to have a foot in the door, for there is no doubt share prices will rise even though the metrics of the industry are not yet mature. In other words, we do not know what analysts and other investors will think important in a decade or two. But new businesses create their own measures. When the dot-coms were new and anything with a dot or a com in the name was hot, the metrics of value included how fast the companies burned up their capital. This was seen as a good thing, even though for most firms the idea and goal is to build up capital, not to destroy it. Fashions come and go. Capital burn was a bad idea then and, in retrospect, ridiculous.

The issue and the divide between good investments and disasters waiting to happen is the quality of decision making. Here we can refer to studies on peer pressure. Seminal studies of group versus individual thinking show that people in groups focused on a problem are more productive when they ponder on their own than when they cerebrate together.³ An experiment proves the point. Between 1951 and 1956, a psychologist named Solomon Asch conducted experiments on the dangers of group influence. He gathered student volunteers into groups and asked them to take a vision test. He showed them a picture of three lines of varying lengths and asked how the lines compared to each other. The question was simple, and 95 percent of students were able to rank lines from shortest to longest and determine which matched others. But when Asch planted actors in the groups who confidently gave incorrect answers, as he had instructed them to do, only 25 percent of the volunteers gave correct answers. The other 75 percent went along with the misguiding volunteers.⁴

CROWD MENTALITY

The urge to get into a hot stock is a form of groupthink. That urge not to be left behind can be stimulated by stories in the press, by good news planted by corporate public relations departments, and by confected stories that a fund or famous investor can’t take on any new clients. That was the modus operandi of Bernard Madoff, who, with a reported US$52 billion overstatement of assets, is the biggest crook of all time.

Madoff’s technique was not to beat the drum for his funds; rather, he told prospective investors that he could not possibly take their money. It became a contest among the wealthy to get in. He identified the bandwagon effect and raised the gate for entry. Refusal of fresh money was only a gambit, for he took as much as he could. As with a restaurant in Manhattan known for exotic prices and snotty waiters, reservations a month in advance backed by a credit card, and the threat of charge for not showing up, the barriers to entry were the enticement. This was reverse psychology applied as a sales technique. And it worked.

What Madoff did was to add roadblocks, and that made his game all the more prestigious. Results were unusual in that he claimed to have steady returns of 8 percent a year in and out of good and bad times. Such returns with almost no variation can be achieved with perfect options tactics, but that is very difficult to do and highly improbable. Corporate finance experts doubted his record was real and communicated their concerns to the U.S. Securities and Exchange Commission, and the SEC ignored the warnings.

The great bubbles in history include the Dutch tulip mania of 1634 to 1637, the British South Sea Company of 1720, the French confection called the Mississippi Company of the same year, the global stock inflation of the 1920s, the Japanese property bubble of the 1980s, the dot-com bubble of 1998 to 2000, and of course the great mortgage flop that ended in 2008 with the evaporation of trillions of dollars of debt wealth that had been built on mortgages that should never have been issued and that wound up in default.

Bubbles are diverse in place, time, and substance, but all have the same element — the desire among outsiders to get in.

The biggest Canadian flop was Nortel Networks, shares of which were, at the beginning of the millennium, a third of the total value of all stocks listed on the Toronto Stock Exchange. Shares peaked on July 26, 2000, at $124.50, which would be the equivalent of about $210 in today’s terms after inflation. Shares were worth just 39 cents before bankruptcy filing on January 14, 2009. What had propelled Nortel to the position of the biggest stock in Canada was not only the rush of investors to get in, but also the reluctance of fund managers to miss out. After all, press reports called Nortel “the centre of the universe,” and sheer momentum investing was evidence of people piling into the hottest stock in the land. It was a large cap behaving like a small cap gold mine that had just hit a vein of ore that, no matter how improbable it seemed, would not even need refining. On October 24, 2000, Nortel shares had the first of what would become many major tumbles, plummeting after revenue growth missed the company target. In 2009, Nortel filed for bankruptcy and its shares were delisted by the Toronto Stock Exchange.

These bubbles are diverse in place, time, and substance. But all have the same consistent element — the desire among outsiders to get in. Early participants see their stakes soar, the process is glamourized in the press, outsiders figure that they must not miss the boat to financial paradise, and then it all ends with massive losses.

Crowdthink is not limited to suckers throwing their life savings into improbable small caps. The rich do it, too. The Madoff scandal was unusual in that it spared almost no one who gave Madoff money, but it, of course, was an engineered flop peddled to the affluent who wanted nothing more than stable returns.

Madoff’s victims included Elie Wiesel, winner of the Nobel Peace Prize in 1986, and many charities. All believed in the Madoff gimmick of steady though unspectacular returns. The investors were risk averters yet unwittingly took on the huge risk of fraud. Madoff’s financial statements were superficially proper, but in the details there were clues. The Madoff funds were audited by a man deep into his Social Security years in a tiny office in a suburban strip mall. Ironically, when critics of the business asked regulators to look in, nothing was done. So the con went on until the contradictions were too large to be ignored. Madoff ran out of money to give to clients who wanted to cash out. Then the walls came tumbling down. It was a bubble that, in the end, few had dared to deflate.

THE ODD ECONOMICS OF CROWDS

The bandwagon effect has companion irrational pricing behaviours, each of which an investor should sense and then avoid.

The snob effect. People buy into an idea, a product, or an investment because it is rare or not widely owned. A price tag of seven figures for Andy Warhol’s soap boxes or soup cans is not based on the intrinsic value of a copy of a box or can; it is an entry into a community sharing an idea. Buyers are to be seen as clever for having gotten the irony. And rich enough to buy into the concept.

Prestige pricing. In February 2015, a painting of two Tahitian girls by Paul Gaugin was sold, reportedly to a museum in Qatar, for US$300 million. That price was surpassed by the sale of a picture called Salvator Mundi thought to have been painted by Leonardo da Vinci. The price as reported was US$450 million. Doubts were expressed as to its authenticity as a da Vinci, but we’ll accept that it is the real thing.⁵ However, price and even rarity do not make it more valuable than Rembrandts hanging on museum walls, destined never to be sold and, therefore, technically priceless. With no active market in the greatest works of art, prestige rather than sale sets price. People admire the da Vinci in part because it is expensive. Were it priced at, say, $1 million, it would be just another fine picture — very nice, but not quite breathtaking. And at $30, if you can imagine that, it would be motel art. What people admire is not only the image and the remarkable virtuosity of the artist, but the price as well.

Inverse pricing. Fancy Swiss watches are sold as “aspirational”; that is, if you have one, you can say you have arrived. Thus, a real Rolex or Patek Philippe with a five-figure price is a symbol of prosperity. It shows that you have a fat wallet. Or it may show that you are foolish with your money. If the fancy watch did not have a high price, it would not be so desirable. In theory, we admire those who strap lovely timepieces to their wrists, but that admiration is for the name and perhaps the gold, for a $100 digital watch keeps better time than the $100,000-or-more Swiss job with “complications” that can show moonrise on the other side of the planet. In theory, everybody would like one of these, never mind the insurance cost — often 1 percent to 3 percent per year of appraised value — just to walk around with the thing. If you paid $40,000 for the nice gold Rolex, the annual insurance tab could be as much as $1,200. In functional terms, buying one of these puppies is irrational. The point is, the watch with a six- or even seven-figure price tag is not just a time piece. It is a badge of belonging. It is the corollary of the theory of Thorstein Veblen, a Swedish American economist and autho...

Table of contents

• Cover
• Half Title
• Copyright
• Table of Contents
• Preface
• Introduction: The Sense of Investing in Others’ Businesses
• 1 Crowds: There Is Wisdom in Collective Judgment, but Tragedy Lurks
• 2 Leverage: Using Others’ Money to Make Your Own
• 3 Valuation: What It’s Worth
• 4 Bonds: Evaluating the Risks of Return of Your Capital
• 5 Stocks: Sharing in Ownership and Risk
• 6 Real Estate: Huge Rewards and Lots of Headaches — How Fortunes Are Made and Lost
• 7 Mistakes: Turning Bad Experiences into Assets
• Conclusion: Trading Risk
• Acknowledgements
• Notes
• For Further Reading
• About the Authors