Several years ago, John Kay, famous scottish economist and Financial Times columnist, told, in an opinion piece, the parable of the ox, transcribed below:
“In 1906, the great statistician Francis Galton observed a competition to guess the weight of an ox at a country fair. Eight hundred people entered. Galton, being the kind of man he was, ran statistical tests on the numbers. He discovered that the average guess was extremely close to the actual weight of the ox. This story was told by James Surowiecki, in his entertaining book The Wisdom of Crowds.
Not many people know the events that followed. A few years later, the scales seemed to become less and less reliable. Repairs were expensive; but the fair organiser had a brilliant idea. Since attendees were so good at guessing the weight of an ox, it was unnecessary to repair the scales. The organiser would simply ask everyone to guess the weight, and take the average of their estimates.
In the same way, the psychology of herd investing follows a pattern, just like a pendulum. From optimismo to pessimism; from credulity to scepticism; from fear of missing out on opportunities to fear of losing money; from the will to buy to the urgency in selling.
A new problem emerged, however. Once weight-guessing competitions became the rage, some participants tried to cheat. They even sought privileged information from the farmer who had bred the ox. It was feared that if some people had an edge, others would be reluctant to enter the weight-guessing competition. With only a few entrants, you could not rely on the wisdom of the crowd. The process of weight discovery would be damaged.
Strict regulatory rules were introduced. The farmer was asked to prepare three monthly bulletins on the development of his ox. These bulletins were posted on the door of the market for everyone to read. If the farmer gave his friends any other information about the beast, that was also to be posted on the market door. Anyone who entered the competition with knowledge concerning the ox that was not available to the world at large would be expelled from the market. In this way, the integrity of the weight-guessing process would be maintained.
Professional analysts scrutinised the contents of these regulatory announcements and advised their clients on their implications. They wined and dined farmers; once the farmers were required to be careful about the information they disclosed, however, these lunches became less fruitful.
Some brighter analysts realised that understanding the nutrition and health of the ox was not that useful anyway. What mattered were the guesses of the bystanders. Since the beast was no longer being weighed, the key to success lay not in correctly assessing its weight, but rather in correctly assessing what other people would guess. Or what others would guess others would guess. And so on.
Some, such as old Farmer Buffett, claimed that the results of this process were more and more divorced from the realities of ox-rearing. He was ignored, however. True, Farmer Buffett’s beasts did appear healthy and well fed, and his finances were ever more prosperous: but, it was agreed, he was a simple countryman who did not really understand how markets work.
International bodies were established to define the rules for assessing the weight of the ox. There were two competing standards – generally accepted ox-weighing principles and international ox-weighing standards. However, both agreed on one fundamental principle, which followed from the need to eliminate the role of subjective assessment by any individual. The weight of the ox was officially defined as the average of everyone’s guesses.
One difficulty was that sometimes there were few, or even no, guesses of the oxen’s weight. But that problem was soon overcome. Mathematicians from the University of Chicago developed models from which it was possible to estimate what, if there had actually been many guesses as to the weight of the animal, the average of these guesses would have been. No knowledge of animal husbandry was required, only a powerful computer.
By this time, there was a large industry of professional weight guessers, organisers of weight- guessing competitions and advisers helping people to refine their guesses. Some people suggested that it might be cheaper to repair the scales, but they were derided: why go back to relying on the judgment of a single auctioneer when you could benefit from the aggregated wisdom of so many clever people?
And then the ox died. Among all this activity, no one had remembered to feed it.
With this parable, John Kay shows us there is a completely unnecessary complexity in the financial markets and its result for the investor is zero or even negative. So much activity, so much sophistication, so many resources spent and in the end the ox dies?
The best foundation for sucessful investing is value. The scales allow us to know the weight, the value and what can be extracted from the asset. We need a solid estimate of the value of what we are trying to buy.
Our estimate of value must have solid factual and analytical foundations. That´s the only way we can know when to buy or sell. Only a very strong sense of value can provide the necessary discipline to lock in profits in an investment that has risen strongly and that everyone believes will continue to rise; or to hold that stock and buy even more even if it falls in price everyday. Our estimate of value does not need to be precise. It must however be approximate.
The relationship between price and value holds the key to investment success. Buying below fair value is the most dependable way to profits. Paying above value rarely works.
In the short run, the market is a voting machine – reflecting a census that requires only money not inteligence or emotional stability – but in the long run, it is a weighing machine – scales
The relationship between price and value is influenced by psichology and technical factors, forces that can dominate fundamentals in the short term. The extreme variation in prices due to these factors give rise to great profits or great mistakes. To achieve the former and avoid the latter, we must remain loyal to the concept of value and deal with the psychology and technical factors.
Economies and markets have positive and negative cycles. Whichever direction they take, people believe that direction will be eternal. This way of thinking is very dangerous because it poisons the markets with extreme valuations and inflates bubbles and panics from which investors are unable to escape.
In the same way, the psychology of herd investing follows a pattern, just like a pendulum. From optimismo to pessimism; from credulity to scepticism; from fear of missing out on opportunities to fear of losing money; from the will to buy to the urgency in selling. The swing of the pendulum maskes most people buy high and sell low. Being a part of the herd is a recipe for disaster whereas swimming against the tide helps avoid losses and eventually will lead us to success.
For most professional fund managers, prisoners of quarterly performance evaluations – and of all the system displayed in the parable of the Ox – the value of an asset is what somebody else is willing to pay for it.
By contrast, for a value, and therefore patient, investor, um asset is worth the highest of its fundamental value or its market price: if the market price is higher than the fundamental value, the investor can sell and look for another investment opportunity. If the market price is below the fundamental value, the value investor will keep on holding the asset and benefitting from its cash flows.
As Ben Graham and Warren Buffett have been telling us for decades, the volatile Mr. Market (who, sometimes, is willing to buy you things for more than they are worth or sell you stuff for less than their true value) is our friend, not our enemy. The value investor has an enormous advantage; he uses the “scales”, he rejects the opinions of the crowd, the unnecessary consultants, the soothsayer analysts and acts based on the value of the asset.
“In the short run, the market is a voting machine – reflecting a census that requires only money not inteligence or emotional stability – but in the long run, it is a weighing machine – scales”.
Market prices represent a short term popularity contest (sometimes irrational), similar to an election. In the long run, however, market prices incorporate returns on the company´s invested capital, economic growth and inflation (and for investors, dividends paid) – like a scale. 2016 was a very good example of this.
Happy new year to all.