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13-Feb-2006
7 Common Roads to Disaster in the Stock Market, by Victor Niederhoffer

It is good to know common mistakes that investors make when they decide to sell a stock, because each brings opportunities for profit. I will try to illustrate each mistake with current examples.

A good framework to keep in mind is that while many ephemeral factors affect the value of firms, their value is based on a discounted value of an infinite stream of future earnings. Also good to keep in mind is that there is immense competition in all aspects of business. Whenever opportunities for above-average returns on capital emerge, other firms will attempt to enter the field or innovate with better products or lower prices, based on superior methods of production or distribution. Whenever the price of a good rises, consumers will tend to substitute another good that can provide superior utility per dollar of cost, starting with the least valuable uses of the good whose price rises.

The balance between all these factors -- the innovativeness of the entrepreneurial spirit, the availability of capital and the incentive to make a profit -- has led to a situation where all over the world the return from investment in seasoned equities has averaged some 10% a year for the last 150 years. Any factors that lead to excessive selling based on ephemeral factors extraneous to these principles provide opportunity for profit.

Seven Common Mistakes

1. "Company X's P/E is too high." Because of retrospective biases, data mining, failure to properly date the announcement of earnings and note that good surprises tend to lead to higher prices, thereby making the lower p/e at the cutoff date before the announcement show inordinately high returns, throwing out of the study the low p/e's that go belly up, the tendency for negative reviews to be taken more seriously than positive reviews, the ease of remembering fallen stars, the failure to take account of interest rates, the ecological fallacy and numerous other biases described in PracSpec there is a line of thought that whenever a company sells at a high P/E, it is overvalued. A current version of that is a company like Google has a p/e of 40, but if any little thing doesn't go right, the stock will immediately fall to a P/E of 20, for a slightly better-than-average company, and when applied to the then disappointing earnings numbers , say 10% below expectation, a 50% drop will ensue. The fallacy here is to assume that the current value does not already reflect investors taking into account the possibility of competition and missed earnings estimates. The competition for a company with 50% profit margins and 50% return on capital is always going to be high. The question is how long will it take before that competition reduces the prospective rate of growth to a level that is standard for the economy. Notably absent from all the talk about the competition for Google is that in addition to a nice algorithm for determining which items people are most interested in when they search, the company also has a few hundred thousand computers wired together that provide the fruits of that search in a half-second or so. Also absent are the costs of gaining information, the tendency of consumers and advertisers to purchase from companies they trust, the cost of switching or of searching for other vendors, the repeat business from existing customers, the growth of the basic business, the importance of the brand name, the stiff competition from rival firms Google has faced from its very inception. If ever a company had an insurmountable lead over the competition in a business growing as fast as this, I haven't seen it.
2. "The customers are stupid." They don't realize they're being charged for fraudulent clicks. The idea that a advertiser doesn't measure the results of advertising and doesn't know the value of a sale that comes from each element of its direct marketing budget is an absurdity to those who have been in the direct marketing business. Everything is measured. Everything is quantified and compared to all substitutes. Apparently the online advertising industry is growing 50% a year or so, and the advertising on traditional media is flat to up a few percentage points. Is it really likely that companies like Wal-Mart and AOL don't know what the value of a sale is, or that they care if they're paying x or x + 10% a click when what they're interested in is what the marginal cost of an advert expenditure is? It's even more ridiculous to think that the small retailer who spend $1,000 bucks on an ad doesn't know what the value of sales is. He's paying for the ad and ringing up the sale in the cash register. You don't stay in business too long if you spend money on ads that don't bring in revenues. And owners of small businesses are very much concerned with their own welfare. With all the faults of the pay-per-click ads, the industry is growing 50% a year. Are all those advertisers really so naive that they don't understand that the cost per true, interested, clicking customer must be adjusted based on the spamsters?
3. "The expenses are understated because they fail to account for the cost of options, so the P/E is really too high." It's a major tenet of investment that rational expectation rules. This is certainly true for anything so well advertised as option expenses. Numerous analysts point out what the expenses would be if stock weren't used as an inventive and what the balance between additional stock issued, additional salary expense, and the change in incentives of personnel might be. These are taken into consideration in the price, at this very moment in every company and that's why the companies that switch from one method to another show no differential in their performance.
4. "The market's in a holding action because of fears, doubts and uncertainties." Yes, that's when the opportunities for profit are greatest because the required rate of return goes up. And that's why the IPOs have gained about 50% a year for the last three years -- because of this excessive triangle of worries that resulted from this inordinately salubrious-for-the-future period in which stocks have not risen over the last seven years.
5. "The stock is down 35% from its high, but it won't be finished until it goes down 62% to its Fibonacci retracement." Like the vast majority of technical analysis mumbo, this kind of statement can't be tested. You wouldn't be able to tell the high or low until after the high or low occurred. Moreover, there are many different ways of describing the waves that constitute the basic difference equation of X(t)= X(t-1) +X(t-2) that is at the heart of all such magic. In a nice part of EdSpec, I document how two different Fib analysts, working at the same time with the same data, were able to predict a Dow of 10,000 and a Dow of 500. In many posts on this site, I have shown with simulation how scientific analysis of turning points in the Dow over time leads to results completely consistent with randomness, even though you can point out 10 times that it would have been good to buy and 10 times that it would have been good to sell over the last 50 years with profits 10 times as great as the buy and hold, if only you knew these points in advance. The same is true for filter rules that sell when a stock has gone down x% from a previous high. None of them can make money unless they have survivor bias, because they can't overturn the steady beat of the tom tom buy and hold.
6. "A investor or analyst thinks the stock is too high and could fall by 50%." Yes, there's always going to be an analyst who thinks the stock is too high and another who thinks it's too low. In the Barron's article on Google, much prominence is given to the analyst who thinks it should be 150, and mentioned as a ridiculous aside is the analyst who thinks the right price is 1,000. But do such analysts actually make money on their predictions? If there are more analysts on one side than another, is it bullish or bearish? Of course, someone who works for the "Cautiouses" or who missed out on buying the stock at the IPO, or who's lost a fortune by shorting in the past relevant period and is trying a Hail Mary that might possibly make 1% back is going to be bearish, and of course the investor who owns the stock is going to be bullish. What value is it that Legg Mason thinks it good and the "Cautiouses" think it bad because others might come up with a better search engine? You know, Federer has many competitors with more muscles and more speed. I'm afraid his winning days are numbered and he should sell at a 20 P/E right now.
7. "The executives are very liberal and principled, and can't run a profit-oriented business." Let me start by saying that the idea that the two founders are so pristine, so ethical that they are unfit to run a profit-oriented business for stockholders is an absurdity to anyone who has read anything about their personas and the path that this company has taken in its tortuous road to the top. Perhaps best typifying that the honest duo is at least as subject to the moral laxity as you and I is the fact that all the ads on their site, the ones that generate the bulk of their $6 billion revenue and are completely invisible to 99% of their customers, are called not ads but "sponsored links." Yes, of the 10 richest people in the world, there's not one who's not a card-carrying agrarian reformer -- starting with the Palindrome, the Sage and the Genius Harvard Dropout. Somehow they realized that in order to tap the mass mind, they had to subscribe to the same egalitarian redistributionist principles that are taught from the day they enter school by the state operatives. Yes, it's true that Google's two founders make a big deal about not caring about profits and just wanting to improve the Internet and solve the human genome, and that unlike other companies a very large share (3%?) of their profits go to socially conscious causes, and that all their employees are given one day a week off like the academics. Yes, they're utopian. That's true, until they have to negotiate a deal leaving anything for the other side. (Why does the proverbial words, "the nearer the church, the further from God" float in the mind?) A reading of the puff book that turned me around shows countless examples of the extremely street-smart negotiating ability of the founders. Consider how they were able to start a bidding war with two investment bankers to raise their capital; how they were able to value their company at $100 million or so when all they had was an idea, a program and a garage while the other Internet stocks were already smoldering; how they were able to put off hiring a CEO despite constant hectoring from their backers for two years; how they were able to work out compromise after compromise on such issues as China and pornography censorship. And yes, they're fighting the U.S. government over privacy, and each buck they spend on it comes right out of earnings. However, I would speculate that somehow they will be able to work out a face-saving and profit-enhancing settlement.

I mean this enumeration of common mistakes as a template for meals for a lifetime. Numerous other common errors -- mainly related to confusing the short run with the long run, neglecting to compare alternatives and failing to test whether a given event was bullish or bearish -- are outlined in PracSpec, and formed the basis for the 50% rise in the market since that time.

The more articles there are that talk about some consistently bearish analysts who have sold this stock or are currently short the stock, and have not yet gone belly up the way almost all of them eventually do (the last short selling fund closed down at the end of 1999 in the last cycle), the more opportunities there will be for those who follow the Triumphal Dimsonesque, Lorie and Fisher message.

P.S. This exegesis on common roads to disaster is inspired by the financial weekly news story titled "In the Drink" by Jacqueline Doherty. On the first page of the article she summarizes her projections:

To get a sense of what might happen to the stock, we gave one über-bull's 2006 revenue estimate for Google a 20% haircut, trimmed his projected expenses by 5% (but no further, because bulls greatly underestimate Google's costs), deducted stock-based compensation and, generously, gave the company credit for the considerable interest income on its cash. The result: Earnings would be 30% lower than the bull's projection, at $6.28 a share. If the stock were to maintain its current multiple of 41 on those lowered earnings, it would be worth $257. It's more likely the multiple would shrink to as low as 30, in line with the slower growth. That would make the stock worth $188, versus its recent $360.

The author apparently doesn't consider what would happen if an über-bear's revenue estimate were to be given a 20% kick in the pants and the expenses increased by 5% but no further because bears generally underestimate the latitude for decreasing expenses by reducing such things as research expense which have been increasing ferociously. If the stock were to maintain its multiple it would be worth approximately $600. The story, and related bearish pieces surrounding it, travels on almost all of the seven roads mentioned above. Particularly well traveled is the road that competition from Microsoft and complaints from customers could make the über-bull's projections too great. I would recommend reading the puff book, The Google Story for a blow by blow description of the many past encounters between the two companies on this front reminding one of the likely outcome of a series of virtual match-ups of Federer versus Connors today or Laver versus Mulloy from the past. .

You know, Federer has beaten many competitors with more muscles and more speed than himself, and many of the shots he used to win the last 3 Majors were lucky and based on fancy footwork and only good for hard surfaces.

The last time he beat Agassi he made some crucial points in the first set by hitting the edge of his racket. . Furthermore, one fourth of his points won on serve were won by aces. And the French Open in the next quarter is on clay where no aces will be possible. Next time they meet there is no way he could ever win. Federer makes an average of 5 backhand errors down the line each game. That kind of ferocious going for the jugular is bound to cost him. Furthermore, he's Swiss and aloof and really doesn't seem to care as much about winning as those competitive and hungry up-and-comers from Eastern Europe.

The fight he had with the Federation is bound to take away his energy over the next several years also, and they have never been known to lose a fight with one of their players. If you fight with the devil you need a long spoon. When he played in the China open, he paid a visit to the party leaders there and agreed to wear red socks just so he could compete for the 2 million dollar first prize. It would have been much better if he didn't play in that tournament. Even worse, waiting in the wings to play him in the second quarter at Wimbledon is Ivanisevic and Mojo, who are practicing their serve right now, and have both been clocked at 150. The odds on Federer winning the French and Wimbledon in succession in Ireland are 1 to 2 in his favor. I'd say that's much too low, but I am more of a football and cricket connoisseur.

(One of the difficulties with written communication is that it's hard for an amateur like me to show that he's speaking tongue in cheek. Let it be noted that I admire Federer and don't think his opponents or these fake critiques, idempotent with the ones that have been leveled at Google, have any merit at all.)

The article is so bearish about Google it could have written by Alan Abelson himself. It certainly uses all his techniques:  the testimonial quote from the revered old friend, the glittering generality, the card-stacking with selected numbers to make a point, name calling, the "plain folks" tone, the bandwagon, the appeal to authority, et al. To back up her point about the risk posed by a lofty stock multiple, the author appeals to authority in her first card:

"Google reminds me very much of what went on in 1999 and 2000," says Fred Hickey, editor of the well regarded High Tech Strategist newsletter and a member of the Barron's Roundtable. " The valuation is insane, relative to what they do. "

Apparently not worth noting is that the well regarded one is a well known permabear and friend of Abelson who has been bearish for at least the last five years on tech, who uses a fax machine as his distribution mechanism. While not still editor of Barron's, apparently the bearish financial columnist's influence lingers on at the paper. Other stories in the weekly include "The Trader" column's "Bulls Are Fighting the Old Ennui": "A midweek rebound steadied the market, but any pep mustered was quickly sapped by mounting concerns about economic growth," as well as "Housing Bomb Set to Explode," "Bon Voyage?

 This IPO May Never Happen," "Day of Reckoning," and the curmudgeon's column itself, which points out the disaster that would occur "if the foreigners holding our dollars one day decided to call in their loans."

P.P.S. It is impossible to keep up with all the negative things about Google that are coming down the pike. The latest I have heard is that much of their gains in earnings comes from a gain in interest revenues, and that this cannot continue. Again, are people that stupid, that they care that the net gain in non-interest earnings was 55% rather than the 75% with interest. Is it not possible that without all that interest income that Google might not have spent so many hundreds of millions on projects like connectivity over the normal phone lines, the digitalization of books and the mapping of the genome? Are these and the dozens of other projects they are involved in, in the way of out of the box research, really totally worthless or might one hit big? How long does it take a company to quadruple its earnings growing at 50%?

P.P.P.S. I have never performed a written analysis of an individual stock before, and I am in completely uncharted waters -- or, as Tom Wiswell liked to say, "I'm in over my head." I should point out that there is no reason for anyone to find what I say worthy of any more merit than the numerous contrary opinions about this company. Indeed, because I am long the stock, what I say must be taken with even more salt than would be appropriate for a novice, because it would be hard for me to say anything that would be against my self-interest even if I thought I was being objective. I would also note that while I have been investing in individual stocks off and on for over 50 years, my track record in such investments appears to me to be somewhat worse than random selection and considerably worse than a buy-and-hold strategy.

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