An interesting phenomenon is when investors agree on valuation but incorrectly attribute the source of the valuation. The result is that incoming investors or buyers of the firm end up paying the sellers for value that the buyers create.
A common occurrence is when a start-up sells out to a major player, especially in the services industry. Imagine that there is a local start-up, which we will call Triangle, sells a particular service offering into the market.
Valuation techniques and methodologies are usually taught within the context of developing a financial model or using comparative ratios. In real life the actual decision makers might use the output of these models but will not be the ones who develop the models. Decision makers will also be influenced by other factors, not all of which are rational.
I have seen many examples of this and there are certain repeating patterns that are worth examining. In this post I will concentrate on how equity dilution leads to misperceptions and mistakes.
Here’s the reason market timers lose money: They are traders instead of investors, and as discussed in a previous article traders are time sensitive as their main dependence is on price movement. Therefore they need to invest as close to the upturn in price as possible and they need to hold on and exit only when the price stops appreciating.
Investors, though, can trade the cycle to their profit as an overlay strategy. What is an overlay strategy? It is an extension of an existing strategy. An enhancement. It makes sense only if the underlying strategy makes sense.
The perennially favourite discussion topic is trading versus investing. What’s the difference? Is it short time horizon versus long time horizon? Is it growth versus value? Is it Soros versus Buffet?
This post is a continuation of my 2007 article in The National. Reading the previous article is not necessary to benefit from this post, but looking at the ideas across an eight year period might be helpful.
The thing about the rational investor hypothesis is that it assumes that investors wish to maximise a financial risk/reward function. They don’t. Investors have a utility function that includes economic considerations, but also includes many other goals important to the investor.
Some investors may refuse to invest in defense companies, especially those that produce offensive weapons. Others may avoid investing in companies based in countries who have policies that they don’t approve of. Still others may reject gambling or alcohol related companies. The list goes on.
Whilst economists discuss such issues ad nauseam, traders make money off it. A non-financially motivated seller nearly always provides an opportunity for the astute, and differently motivated, investor to make money.
Many of the ideas used by the investment community are adopted from the horse track and casino betting communities. Much of the failure that has dogged the investment community is due to rocket scientist PhDs misunderstanding the successful models of plebeian punters. The use of betting as an example is not an endorsement, just history.
To understand how the securities markets work you have to look no further than the horse bookies. Bookies take the bets from the bettors. This is the first point that the public begins to misunderstand how betting, and therefore investing, works.
There are two potential misunderstandings: The first misunderstanding is assuming that each horse has a uniform probability of winning, i.e. they are all just as likely to win. The second misunderstanding is assuming that the bookie offers one to one payout odds, i.e. pays $1 for each $1 that is bet. Grasping the significance of these statements is the key to successful investing.
The bookie, equivalent to the investment bank or broker, will always make money. Always. They do this because they do not set payout odds depending on which horse they think will win, they set payout odds based on how people bet.
The business performance of car rental agencies was historically volatile. Part of this was simply due to the inability of car rental agencies to predict client behaviour. However, this did not explain all of the variance in their business performance. It was only as the rental companies began to realise that their business was not just to provide a service, i.e. renting cars, but that they also were producing second-hand cars. It was the understandable misunderstanding by the rental companies of this facet of their business that was causing them so many problems. We can learn from this. Continue reading
Buying a home is an admonishment that is drummed into the heads of most people. Buy don’t rent. Renting is throwing money away. At least if you lose everything, you’ll have some place to sleep. At least that’s what people say. But is it rational? Before you decide to invest such a large amount of money, don’t you want to analyse it a bit? You know, the same way you analyse a share purchase that costs a fraction of the cost of a home? Or analyse the merits of a Samsung versus an iPhone?
I think that the main confusion is due to the fact that there are several issues interwoven into this decision. In particular, two cash flows are being net off, thus hiding a valuable insight. To understand this, consider somebody who is renting a house. He pays rent to the owner of the house which results in a cash outflow to the renter and a cash inflow to the owner. When the renter is the owner these two cash flows do not go away, they just cancel each other out. Absurd as this may initially seem, getting to grips with this unintuitive insight is key to making intelligent investment decisions. Continue reading
They say that information is power. Data providers think so. Prices delayed by 15 minutes can usually be had for free, but real time prices cost thousands of dollars per month. Data providers and hedge fund managers will place their own servers in the same building as that of a securities exchange, just so that they can gain an extra few microseconds of an information edge over the rest of the market.
High frequency traders pay exchanges to allow them to see prices a split second before anyone else (don’t ask me how this is legal, it certainly isn’t ethical). There are strong insider trading laws banning the use of information that is obtained inappropriately, another pointer to the value of information. Continue reading