Part 4 (1/2)
Chapter 8
Searching for Stunners
The damn ' d South Sea The additional rise of this stock above the true capital will be only iar arithmetic, will never make three and a half; consequently, all the ctitious value must be a loss to some persons or other, rst or lastThe only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the hindmost
-Unknown contemporary commentator, on the South Sea bubble The South Sea Coant solution to a number of disparate proble public debt by converting governhts to Spain ' s A chip with the belligerent Spanish king, and the venture, if successful, promised to ll the coffers of the Exchequer with
substantial trading protsYet despite support froe was appointed Governor of the CouishedThe ” trade monopoly ” secured over the Spanish Americas was pitiful, in both senses of the word: an annual quota of 4,800 piezas de Indias (ht), as well as one shi+p per year carrying oodsThe venture yielded no substantial pro t and, in any case, ith Spain in 1718 effectively terhts of the Company
The fortunes of the South Sea Coor-ated in March 1720 when it won a bidding contest against the Bank of England to acquire s swap In an effort to procure a favorable exchange rate for the conversion, promoters talked up the prospects of the Coant ru concessions with the New World Stock prices rocketed from 128 per share in January 1720 to just over 1,000 less than sixday traders ' chat rooms of our era, the boost-erism of Company directors was abetted by stimulant - stoked chatter in coffee houses and wildly optiled ht up in a fetish for easy money Samuel Johnson later noted that ” even poets panted after wealth ” - Alexander Pope, he wrote, ” ventured soht hiht in the riptide of greed, Pope still had an eye to the deleterious effect of South Sea hysteria, which diverted the populace from the banal, but necessary, responsibilities of everyday life: No shi+ps unload, no Looms at Work we see, But all are s ' d by the das in real property, were par-ticularly enthusiastic participants in the stock h, realized that prices for South Sea stock were not anchored to any bed of true value: Every -ures, sees that ' tis not possible by all the arts and tricks upon earth long to carry 400,000,000 of paper credit with 15,000,000 of specie This makes me think that this project
The duchess - who, her great - grandson Winston Churchill would later remark, possessed an ” almost repellent co the then astrono couple ofheavily secured loans to some of her more bullish peers Ultiood fortune - prompted by the failure of a si ports due to the Plague, and perhaps affected by a general credit squeeze, the bubble eventually burst By Dece an almost perfect parabola on the share price chart, South Sea paper traded at exactly the same level as at the start of the year
As the duchess of Marlborough shrewdly observed, stock exchanges can at times confect prices which veer considerably fro value Almost three centuries later, despite - and often because of - the sophistication of es, stockand value radically diverge Like the duchess, Maynard Keynes con-cluded by the early 1930s that, as one of his biographers put it, ” the laws of arithmetic were more reliable than the winds of ruround investment decisions in ther as impalpable as ” market sentiment”
Nullius in Verba The seekers after perpetual
-Sir Isaac Newton (attributed) In July 1720, the British parliament passed the ” Bubble Act,” which prohibited the formation of joint stock coh soislation was to allow the South Sea Company to corner the market on investor credulity, the ostensible explanation for the Act was to curb the speculative wildre ignited by the South Sea bubble Exploiting the ” inordinate thirst of gain that had af icted all ranks of society ” during the mad days of early 1720, other company promoters had atte a hush - hush enterprise ” for carrying on an undertaking of great advantage, but nobody to knohat it is,” and another to build a wheel for perpetual motion
Isaac Newton - the practitioner of ” cold and untinctured reason ” in his scienti c endeavors - became the most famous ” cully ” , or vic-tim, of the South Sea hysteria Perhaps the continued rise of South Sea stock in the summer of 1720 convinced hi, that Britain had indeed stumbled on a corporate El Dorado In any case, the e toffs, supporting hi the bedpans of his uiled by the vision of abundant wealth shi+ on the horizon He, like so many others, became intoxicated by the ” unwholesome fermenta-tion ” produced by the action of animal spirits, in which ” the hope of boundless wealth for the ant for to - day”
Newton, then the President of the Royal Society, the world ' s oldest existent academy of science, failed to heed its eminently wise motto, Nullius in Verba- don ' t take anyone ' s word for it Had he applied the saor to his stock speculations as he did to his scienti c specu-lations, Neould have realized that, just as certain fundamental laws in physics mandate that a perpetual motion machine cannot exist, so too the inexorable rise of South Sea stock could not last Instead of following the crowd, he would have been far better served exer-cising ” his unusual powers of continuous concentrated introspection,” as Keynes characterized what he considered Newton ' s chief strength Upon even a cursory analysis, Neould have concluded that the prices of South Sea shares were levitating entirely as a result of the col-lective will of speculators, rather than by reference to any economic fundamentals
The Economist and the 100 Bill A neoclassical econoreen one day, discussing the ner points of nancial theory, when the undergraduate sights what seerassThe student quickens his pace to intercept the fugitive note, but the econoe” If it really were a 100 bill,” the older man advises, ” someone would have picked it up by now ”
-Market anecdote After his own stock- basing the investment decision on a coainst its asking price - was the best corrective to the periodic visitations of ani repudiates a funda that there can in fact be a sustained divergence between the quoted price of a stock and its underlying value Value investors are fond of citing the rather arch parable of the econo form ” of the efcient markets theory, which states that there are no hitherto undiscovered bargains - and, conversely, no overpriced lees
As characterized by some nancial commentators, an ef cient nancial market is one in which the sheep are protected fro investors will operate to tri up apparently underpriced stocks and selling down overpriced paper By so doing, these stock ilantes - the pike in the carp - pond, to borrow Keynes ' metaphor - ensure that, in theory, unsophisticated investors will not be at the mercy of the smart moneyAs the authors of Principles of Corporate Finance, the bible in undergraduatenance classes around the world, assure their readers: ” In an efcient market you can trust pricesThey impound all available information about the value of each security”
Efcient ths to defend their theory Theyprices of a fervid bull market are justied by a particular innovation or improvement in the economic environment - ” This time it ' s different,” they persuade themselves, as old valuation metrics are casually discarded Former President Herbert Hoover, for instance, recalled the self - servingctions invented to justify the extravagant stock prices of the late 1920s: With the growing optiave birth to a foolish idea called the ” New Economic Era” The notion spread over the whole coun-try We were assured that ere in a new period where the old laws of econoer applied
Stock market players, it is apparent, are sometimes more adept at ration-alization than rationality
Other adherents to the orthodoxy siu-ment that prices must always be correct because they are the product of an all - knowing exchange The coly blinds soes periodically experience spase considerably fro valueThe backers of the efcient markets hypothesis sih wolves to corral the sheep, and that the bleating ock can blindly le into a chas Game It is impossible to avoid a precipice, when one follows a road that leads nowhere else -Jean-Baptiste Say, A TREATISE ON POLITICAL ECONOMY Efcientthat stock prices always incorporate all public infor the value of a security, succumb to an absurdly basic errorAs Warren Buffett has noted: Observing correctly that the market was frequently ef cient, [many academics and investment professionals] went on to conclude incor-rectly that it was always efcientThe difference between these prop-ositions is night and day
Value investors, by denition, do not accept the strong form of the efcient markets theory There are times when the quoted price of a security departs fro value, these investors believe, and it is on these occasions that the intelligent investor seeks to exploit thethat results
Despite their skepticism about the effectiveness of the stock enerally accept that over the longer term stock markets price securities efciently As Keynes coue,” when the safety, excellence, and cheapness of a share is generally realized, its price is bound to go up” Ben Grahay to illustrate this tendency:themachine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accord-ance with its specic qualities Rather should we say that the ister choices which are the product partly of reason and partly of emotion
In the near term, stock prices oscillate around true worth, and at tier term, however, the truth will out As Buffett conore business success for a while, but eventually will con rm it”
Market efciency, for value investors, is therefore a question of ties are invari-ably efcient in the short run, they generally accept that in the long run stockle observes, ” The fact is that when the perception - interim stock prices - vastly departs froap can only be reconciled in favor of reality” This is due to a simple and indisputable ate, can only earn what the underlying business earnsAnimal spirits lack endurance - theyvalue for a period of tis and dividends will determine the value of a business to its owners Empirical evidence conr h year - to - year stock performance is heavily inuenced by price- term investor, the value of a portfolio corre-sponds closely to the present value of dividendsThe present value of the (eventual) capital appreciation dwindles greatly into insigni cance
Bargain Hunting Annual income twenty pounds, annual expenditure nineteen nine-teen and six, result happinessAnnual incoht and six, result ent investors, then, look for stocks where the quoted price has for some reason uncoupled fros potentialValue investing, at its siiven - for a buyer of stocks, securing a stream of cashohose present value is expected to exceed the purchase price, for a seller of stocks, pocketing sale proceeds which exceed any reasona-ble estimate of future dividends As Warren Buffett summarizes, value investors:search for discrepancies between the value of a business and the price of small pieces of that business in the marketThe investors simply focus on two variables: price and value
It is on expected earnings and dividends, therefore, that the value investor concentrates, rather than short - term priceuctuations The quoted price of a stock is useful only as a point of reference, in deter- substantiallyvalue of the security In explaining his invest-ue, Keynes remarked that: My purpose is to buy securities where I a power and where the market price seems cheap in relation to these
As Keynes e value of a stock, it is the co power ” that is relevantThe ” intrinsic ” or ” fundamental ” value of a stock is siiven security, appro-priately discounted for the effects of tiht to satisfy value invests ratios, low price - to - book value, and a high dividend yield - are, at best, tools for identifying possibly underpriced stocks Ulti power of a stock that counts
The value investor, therefore, adopts a ” bottom - up,” rather than ” top - down,” investment style - that is, the investor scrutinizes particu-lar stocks in an effort to determine whether there exists a discrepancy between the quoted price of the business and its assessed underlying value Other factors - whether the stock price has trended up or down in recent ti, whether a particu-lar sector is ” hot ” at the ent investor As renowned stock - picker and nancier Sir John Templeton counseled, the disciplined investor should ” buy value, not market trends or the economic outlook” The value investor focuses on speci c stocks rather than the broader index, and re as an undifferentiated ” stock market ” - there is only a mar-ket for individual stocks
Eyes Forward The future ain ' t what it used to be
-Yogi Berra (attributed) Man is a pattern -animal, and seeks to impose order or a raison d ' e tre where it does not necessarily exist He discerns faces in clouds and winning streaks in a coin toss, and three dots on a piece of paper will always resolve into a triangle Likewise in the stock ame players believe that the trend is their friend - that what happened in the recent past is as good a guide as any as to what ht happen in the future As Keynes observed in one of his Chair, ” Speculative ov-ernedby fear more than by forecast, by e of next tienerally rely on past events - pricecues
In contrast, value investors - those who scrutinize individual stocks rather than atte to take the temperature of the market - focus only on the likely future income from a particular security For these indi-viduals, the investment decision is driven not by a mere expectation that prices will rise or fall over the short term, but rather by an assessment of whether stock prices appear cheap or expensive, based on an esti terent investors concentrate on the business behind the stock, speculators on the stock price independent of the business Practitioners of value investing always have intrinsic value as the bedrock of their decision -- price merely offers a point of entry (or exit) to the investor, should itvalue of the security
Virtue Rewarded I a a funda intrinsic values, enormously in excess of the market price, which at so the shi+p ho Director of Provincial Insurance Company,April 10, 1940 Keynes, as one of his Blooain” Notwithstanding his groealth and generousnancial support of the arts, he watched over his personal nances with surpris-ingly keen eyes Keynes was not above haggling with tradesnments of war - issue bully beef because it was only a penny a tin, and hosted dinner parties that were legendary for their frugalityVirginia Woolf noted that on one occasion Keynes served a uests - the visi-tors ' ” eyes gleaulation Bloorouse, hs at Keynes ' expense, but perhaps they missed a key point about the man The reain hunter despite his great wealth, but rather that the bulk of his riches were derived precisely because he was a bargain hunter
In the nal phase of his invest ” stunners ” - those stocks which offered ” intrinsic valuesenorh Keynes professed scant faith in the efciency of nancial exchanges at any given point in tier ternize the value inherent in a security and reward perforent investor, therefore, focuses on the future earnings ability of a particular stock, rather than being diverted by past trends in the market as a whole Short - terenerated by an inux of animal spirits, stock market whims and fashi+ons - all these are of absolutely no i investorThe only relevant factor is the disparity, if any, between price and the estimated intrinsic value of a stock