Dismissing markets as short term ignores the real world cost

There’s an interesting passage in the book “Other People’s Money” by John Kay. In it, Professor Kay discusses the intermediation of the market and the nonsensical notion that there is anything particularly insightful to be gained from “what the market thinks” when it comes to investing in companies. In our presentations we often talk about the market’s inability to assess the strategic value of companies and this itself is an echo of Benjamin Graham’s famous quote: “In the short run the market is a voting machine, in the long run a weighing machine.”

I have some sympathy with Kay’s assertion that “Many senior executives talk privately with contempt of the analysts who follow their company. The chief financial officers and investor relations personnel of large quoted companies engage with these analysts…..in a process of earnings guidance and earnings management that bears little relationship to the underlying business of the company. Most of what is called ‘research’ in the financial sector would not be recognised as research by anyone who has completed an undergraduate thesis, far less a PhD.”

I would disagree with part of this but also go further in criticising the market participants. First I would argue that the majority of sell-side analysts (although not all!) do make a stab at understanding the company that they are looking at – so there is an attempt to ‘research’ the investment opportunity.  However, I would also argue that it is in the second stage of the analyst’s job that the critical error Kay identifies is made. Having spent time getting to know and understand a company (and the sector) most analysts then worry and pontificate about the next quarter’s numbers, and whether they are likely to be better or worse that the rest of the market’s estimates of those numbers.

This is not entirely the fault of analysts. There is huge pressure from traders and depressingly some buy-side fund managers to work out whether next week’s numbers are likely to beat or miss expectations. The market is too busy digesting the ‘noise’ around earnings updates, results, presentations etc. rather than understanding the source of the noise.

Unfortunately, this means that the capital allocation process isn’t efficient. Companies are not being rerated or supported because they are likely to succeed over the long term. Instead companies are supported and backed because they are seen as the most likely to beat the market’s expectations of those companies. Again, we can turn to an economist who can describe what is happening far more effectively than I can; Keynes used the metaphor of a beauty contest in which judgements are based on what the judges think others will think is beautiful rather than what is in itself inherently beautiful.

This is the ground upon which bubbles grow. People buy companies because everyone else is buying them, not because they are worth buying. Analysts recommend buying companies because they are liked by others, and are likely to beat market estimates. It gets worse. In an environment where a company’s share price is doing badly fund managers often avoid owning those shares simply because they are performing badly. Qualitative judgements about a company as an investment are negatively influenced, because the shares are performing badly.  Moreover, judgement of fund managers through performance against benchmarks means that there is huge pressure on managers to succumb to the temptation to join the rest of the market in “voting” rather than “weighing”.

I would like to believe that the market is a weighing machine in the long term, i.e. it will eventually “get it right”. However, this vortex of irrationality can often leave some companies with very significant long-term value potential, wounded, short of options, and short of supporters. The excessive short-termism and “analysis by consensus” means that these periods of share price underperformance leave such companies in a position where the risks to the survival of often good businesses mount significantly – either because they simply cannot use the stock market to refinance in the way they should be able to, or because a predator comes along and picks off the company for a ludicrously low price.

This is not in anyone’s interest; the companies, the end investors or the wider economy.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.