Sunday, November 15, 2009

A Random Walk Down Wall Street: Chapter 3

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Considering the madness of crowds as described in the previous chapter, many investors believe it prudent to attempt to grow their savings and wealth using professional money managers. While professional/institutional money management has grown tremendously in the last few decades (in 1960, only half of all trades were from institutional managers, while today closer to 90% of trades are institutional), Malkiel attempts to show that such managers fall prey to the same vagaries as do individual investors.

Starting from when he first started working on Wall Street in 1959, Malkiel walks the reader through several crazes Wall Street went through over the years that cost investors dearly:

1) The "Tronics" Boom of the early 1960s

Investors were hungry for growth stocks, and the market provided them, as 1959-1962 saw more issues than at any other period. IPOs would trade at several multiples of their prices only weeks after the fact, and regular companies would add a "tronics" suffix to their names in order to boost their stock prices. In 1962, the party ended, with "growth" stocks suffering far more than the general market.

2) The Conglomerate Boom

Two plus two equals five for these acquirers of the mid-1960s. Companies in totally unrelated industries were merging and "creating value" for shareholders with back-end "synergies". Companies trading at high multiples would buy companies trading at lower multiples and thus show earnings per share growth. The combined company would then trade at the multiple of the acquiring company, thereby increasing value like magic! Not only did multiples not drop after such acquisitions, but they would actually rise, seemingly due to the earnings per share "growth" that was occurring. The bottom fell out in 1969 when multiples for conglomerates came crashing back down to earth.

3) Concept Stocks

In the late 1960s, a focus on near-term stock returns led to a boom in concept stocks. These were stocks of companies with little to no revenue, but with compelling stories. Fund managers did not even have to believe the stories, they just had to believe that other fund managers would believe, and that would be enough to buy in, with the hope of selling to a 'greater fool'. The pros lost a lot of money for their clients when the bear market of 1969-1971 destroyed the prices of these dream stocks.

4) The Nifty Fifty

With the silly fads that had taken place in the 60s, Wall Street pros began the 70s with an eye towards quality companies. These companies were big caps (and were thus "proven") and had great returns on capital, and therefore the thinking was that even if prices were temporarily high, the earnings would eventually catch up since the companies were so great. The P/E's of companies like Sony, Polaroid, McDonald's and International Flavors traded above 80, but they would all trade at fractions of this level some years later.

5) The Roaring 80s

A return of the appetite for "growth" companies saw investor demand for new issues once again overwhelm prices. Where electronics companies commanded ridiculous multiples in the 60s, it was biotechnology companies that were favoured by investors in the 80s. Malkiel discusses a few individual stocks to demonstrate how insane even the institutional investor can become.

6) The Nervy 90s

The 90s saw huge bubbles in both internet stocks and Japanese real estate. There was no doubt that the internet would be a game changer, but Wall Street's overzealous demand for internet securities led to ridiculous valuations where companies with no earnings could sell for 350 times their revenues!

While anomalies such as the ones described in this chapter do occur every once in a while, Malkiel takes care to note that in each case, even if it took years, the markets eventually corrected. Therefore, he argues that in the long-term markets are efficient.

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