The end of Alpha

A few hundred years ago, humans were not capable of calculating the speed and acceleration of apples falling from trees, the movement of heavenly bodies and predicting simple things like whether a 2kg ball and 1kg ball will roll down a slope faster. Btw the answer is both balls will roll down the slope at the same speed.

Then came along a guy called Newton who sat down in a park some day and an apple fell on his head. (I'm guessing this guy is a nerd and has no dates!) And as they say the rest is history. Well no offense, Newton was a great guy and I admire him as much as the next value investor reading this blog.

Anyways, the analogy here is that would there be a day when humans can fully predict the prices of stocks and all other investments? And all securities would be priced fairly all the time and there would be no room for speculation and the market becomes truly, madly, deeply EFFICIENT.

Of course, even a genius like Newton failed at winning the stock market (he speculated in the stock market in England during the South Sea Bubble and lost a lot of money) so it may really take a long long time for some achievements on this front. And some may argue that this would not happen bcos stocks move on emotions and no one can predict human emotions. Esp the emotions of the woman whom you decided to spend the rest of your life with.

Well... that's true... but we have also achieved a lot of impossible feats, like going to the moon, heart transplant, calculating a 2 to power of 10mn digit prime no. etc. So let's just for argument sake postulate that some day, all securities are priced efficiently all the time.

What's gonna happen is that capital would be allocated efficiently all the time, all investors will earn the same rate of return and there will be no Greater Fool Games, no bubbles and no crashes.

The stock prices of companies will be step functions corresponding to the growth of the companies. There would be no technical analysis since it's all straight lines now. Any new developments will be instantly reflected in the stock price so you see the prices move vertically up or down. Hence the step functions.

There would be an army of arbitrageurs who would bring the stock price back to its intrinsic value if any punter tries to even move the stock price by 1/256 from its intrinsic value. Btw this value will be calculated accurately to the 10th decimal place all the time and changes accurately to a new value with new pieces of information.

Brokers would still be around but their sole purpose would be to faciliate any trades. They will earn their fair share of commission, probably at 0.0001% of the trade or whatever. There would be no need for analysts or economists babbling nonsense since everyone can simply use bloomberg to find out the intrinsic value of any securities.

Fund managers exist solely to mix and match different securities to create suitable portofolios for their clients who are too lazy to do it themselves. No investor will ever lose unnecessary money except for the case of company bankruptcies. But even so, his portfolio will be protected by insurance. How perfect!

Well, that's a dream. It may happen someday, but most probably not in my lifetime.

Mind Share

This concept should be familiar to followers of the guru and value investing as well. Essentially, we should invest in companies that have a market share of our minds. The bigger the better.

Well, basically, we are talking about branding, but Mind Share sounds so cool right! So let's just use this term indiscriminately in this post.

For the uninitiated, let's try to define what's Mind Share.

In today's world, most of us suffer from information overload, everywhere we go, we get bombarded by sexy ads, bright slogans, spam emails, fancy taglines, funny ringtones etc. We used to just ride a bus. Now we flag down buses with huge ads, watch TV on buses while surfing the net with our PDAs, talking to our gfs/bfs on our mobile and listening to Ipod at the same time!

Everything is trying to get even the slightest attention of our hearts and minds, every minute of the day. In fact, all of us are now superstars, and all the products in our lives are fans demanding attention. So if some products can just get a tiny slice of our thoughts, wouldn't that be very significant? And the fact is, some brands in some products simply dominate people's brains.

Think soft drink -> Coca Cola
Think shaver -> Gilette
Think portable music player -> Ipod
Think search engine -> Google
Think luxury handbag -> Louis Vuitton
Think fuel efficient car -> Prius (or Toyota)
Think diapers -> Pampers
Think cheese -> Kraft
You get the idea, I hope...

One important tenet of value investing is that the business must have very high barrier to entry such that profits will not get eroded by competition. And branding is one such high barrier. Once a brand becomes synonymous with its product, it will take years or even generations to change that. The same goes for bad products. There is even a Chinese proverb: bad name smells for 10,000 years, right?

When a product has significant Mind Share, or branding power, it can command any prices and people will still pay for it. Even if competitors comes up with a better product, Mind Share is so powerful that it negates the positives of the newer product and urge the consumer to stick with the old one. Remember the Pepsi Challenge? People actually like drinking Pepsi more than Coke when subjected to blind tasting, but still, they will buy Coke over Pepsi anytime.

So does it make sense that Buffett owns some of the most distinguished brand names like Coca Cola, Gilette, Kraft? Why doesn't he owns Apple or LVMH or Toyota or Google? That's gotta do with Circle of Competence, which most people don't really practise even if they understand what it's about. That's topic for another day.

Back to Mind Share. If you come across a new product that has a piece of your mind and also a share of the minds of people you talked to, then chances are it has got a significant Mind Share (and most probably market share as well) and it makes sense to think that the business should be worth investing.

Of course, do more homework and research first. The amount of research done is inversely correlated with the probability of losing money!

One final caveat:
Think Efficient Government -> Singapore!

The future is bright for this Little Red Dot. Whether the heartlanders benefit is another question though.

Choosing Numbers, Beauty Contests and Stock Markets

I once attended a class where the professor asked us to play a game. It was a pretty simple game on the surface. Everyone was asked to choose a number from 1 to 100. The person who chose a number that is closest to 2/3 of the average number that everybody chose will win the game.

Now how should one choose such that it would maximize one's chances of winning?

Well, first you must determine what is the average of everyone's number choices. There were about 100 students in the class, so assuming everyone randomly chooses a number, probably the average will be close to 50. So 2/3 of 50 will be 33.

But wait a minute. If everyone thinks similarly and chooses 33 then the average will be 33 and 2/3 of the average then becomes 22.

Hey wait a second, if everyone then chooses 22, the 2/3 of the average will then become 2/3 of 22 which will be 15. And so the reasoning goes.

So in the end, I chose 1, based on the above logic. Of course, I did not win the game. The real winning number, was somewhere between 22 and 33 (I forgot the actual no.). So what went wrong? And what the hell has it got to do with Beauty Contests and the Stock Markets?

Let's talk about the Beauty Contest first. The great economist John Maynard Keynes came up with this concept to explain the stock market. So this Beauty Contest is also sometimes known as the Keynesian Beauty Contest.

Btw Keynes is a big name in economics, if you don't know him, shame on you and pls go check him up on Wikipedia.

Anyways during Keynes time, some newspaper in London publishes 100 pretty faces and asks its readers to choose which face would likely be the pretty face that most readers choose.

So there are people who would simply choose who they think are the prettiest. However that's quite unlikely to win bcos we all have different tastes right? Xiang Yun may be your favourite but I like Fann Wong. Ah Beng may like Auntie Zoe and Ah Seng likes Wong Li Lin. (Ok as you can see, I belong to a dinosaur generation and has no clue who are the new stars.)

So some smarter readers will naturally try to guess who they think the general public will choose as the prettiest face. And just like our number game, even more sophisticated readers can even go further, and choose the face that other readers will choose as who they think the general public will choose as the prettiest face. And one can further increase the order of the guessing game.

Ok if you have been reading intently this far, you would have guessed that the stock market works in a similar fashion. Well that is if you want to pick a winning stock tomorrow, or next week or even in the next 6 or 12 mths.

Basically you can throw fundamentals out the window. Technicals may help a bit but what's gonna make you big bucks is to guess what everyone else is thinking and be a step ahead. The winning stock will be one which the market participants think will have the rosiest earnings growth in the near future. It does not necessarily mean that the stock will actually deliver the rosiest earnings. Just what everybody thinks is what it counts.

Actually the market mostly likely works in the 3rd order: ie the winning stock will be one which most market participants expects most other market participants to like a lot. This is chim, right?

Today, these are your alternative energy, oil exploration, frontier stocks etc.

It does not make sense to go too high into the order bcos the market cannot be too sophisticated as there will always be some uncles, aunties and amateurs choosing their own favourite pretty face (or their own favourite stock). That's why choosing 1 in the number game will not win.

In the stock market, it means that you shouldn't be buying stocks of a company that provides the core component for a high-end analytical equipment used to detect uranium in some desert. And as you know, uranium is used for nuclear power generation - the hot, sexy story in today's environment. The market is not sophisticated enough to think so far ahead. Even though you may be right and the company may have a genuine investment thesis.

This means that you shouldn't be thinking too far ahead of the market. You should be 1 step ahead but not 5 steps ahead. Well, that is if you want to pick winners in a short time frame: ie from 1 day to 6 to 12 mths.

In summary, the stock market works like the beauty contest in the short term. It's the ultimate guessing game and chances of you getting it right is not high unless you have that flair or talent. But over the long run (ie 5 yrs and above lah), stock prices have to reflect fundamentals: earnings growth, shareholders' return and companies' true intrinsic values. And value investing ensures that you have better chances getting that part right.

Zoe, Fann, Li Lin can be Queens of Caldecott Hill but Mother Theresa, Florence Nightingale, Helen Keller are the real winners in life's beauty contest.