Schrodinger's markets

In markets, 2022 was a year of poetic justice. I start from there to revisit a timeless yet confusing characteristic of markets.

Benjamin Graham’s 1955 testimony to Committee on Banking and Currency:

Chairman: When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about – advertising, or what happens?

Mr. Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it in one way or another.

2022 markets were in poetic justice mode.

ARKK. Masa. Tiger. Crap-tech. Dodgy decacorns. Outrageous IPOs. Scammy SPACs. Scammier cryptos, in Bahamas and elsewhere. The list of assets and people that saw their comeuppance in 2022 was heart-warming to anyone who believed in notions such as history, fundamentals, cashflows and intrinsic value. To us fuddy-duddies, Will E Coyote had run off the cliff years ago, but had been suspended in mid-air in a cartoonish defiance of physics. 2022 saw the return of gravity, often accompanied by law-enforcement. That loud splat was the sound of poetic justice. After a frustratingly long wait, the world seemed to make sense again. At the least, make more sense.

Schadenfreude’s nice, especially as it validates a core belief about markets.

It’s politically incorrect to rejoice at others’ misery, but man, Schadenfreude’s fun. The fall of a Thoonicorn that had been shafting consumers felt as satisfying as China reeling from Karmavirus. Part of this schadenfreude is due to envy, a powerful emotion that none of us are immune from, despite claims to the contrary. Investing has no pain worse than seeing a self-delusional nitwit get rich from loading up on ruinous risk. However, a larger part of schadenfreude is due to validation of a fundamental belief in markets, referred to in the Graham quote at the start of this essay. No matter how crazy markets seem every waking hour, deep down, I believe that markets will eventually sync up with the real world. If they don’t, my professional existence will lose all meaning.

But how does this reconcile with Mr Market?

Even Ben Graham expressed two seemingly contradictory views about markets. He explicitly articulated the Mr Market analogy, labelling markets as schizophrenic. He recommended that intelligent investors entirely ignore mad markets, except for rare occasions when madness led to bargains. Yet, the investing philosophy he and his proteges practiced is premised on markets turning sensible over the long run, at least on average. Buffett’s $600 billion arose from markets taking his businesses from under-valued to fairly if not unfairly valued. Schizophrenic, yet sensible. Mad, yet fair. Ignored as crazy, yet the basis for how we’re judged. It’s a bit confusing.

Herein lies the paradox that messes with our minds.

After 2022’s collapse, are aforementioned assets at fair value or even undervalued as Cathie claims? Are we now in sensible zone or still in madness zone? As stuff fell in price from 100 to 20, were markets right at any point of the way? How can we even tell? What does ‘right’ even mean? My ‘poetic justice’ label is value judgment, not fact. Surely, promoters of fallen IPOs would prefer to label it unfair luck. Astute readers will note that I conveniently and hypocritically spared my own ‘quality’ businesses that saw valuation corrections. While I can rejoice at market movement that suits my biases, I am far from being able to make sense of what happened in 2022.

One of two crucial skills Buffett said he’d teach aspiring investors is: How to think about markets. The other is – How to value a handful of sound businesses. While the latter may be more analytically challenging, the former is more psychologically challenging. 2022’s violent corrections offer a chance to visit this topic of how to think about markets. I believe that the answer involves making peace with market’s two seemingly contradictory aspects, without fussing too much over which one dominates at any point. Hence, Schrodinger’s markets.

Efficient and inefficient.

Markets are far from efficient, especially when efficiency is defined as ‘price is right’. Typical stock fluctuates between X and 2X in a given year, making it unlikely that price was right at most times. However, markets are also far from inefficient. While price may not be right in a precise sense, it does seem right in a general sense. Better companies do command higher valuations over time. As do better industries. Ditto with better owners, best seen in divergence between public and private banks. It is this efficiency that makes investing’s holy grail – wonderful business at fair price – a rarity. As rare as a fund manager who outperforms indices. Markets are neither efficient nor inefficient. Maybe they are both efficient and inefficient. Just like with that cat in the cruel box.

Voting machine and weighing machine.

With unicorn IPOs, whether price is 150 or 50, markets are pure voting machine. There’s no weighing machine as no human on earth knows what any of these businesses are worth. Notwithstanding decimal-point pretence, valuation is for rationalizing not reasoning. With many discovered chor companies, market is pure weighing machine. Markets took fallen angels of 2007 bull run to zero for sound reasons. With good businesses that are overvalued, markets are a bit of both. Depending on your biases, you can decide how to split 50 PE across weighing machine and voting machine. With both factors at play nearly all the time in every stock, we’re back to Schrodinger.

Madness of mobs and wisdom of crowds.

Madness and sense appear linked to whether mechanism at work is self-reinforcing or self-correcting. In bubbles and panics, former dominates leading to madness. In end-07, September-08 and March-20, we were clearly driving in ludicrous mode. At other times, the same set of people magically turned into a wise crowd allowing mean-reversion from extremes. Even at the same point of time, both madness and wisdom prevail in different pockets of the market. Frothy IPOs got crushed while rest of India chugged along. While seeming nutty every step of the way, markets are wise enough to somehow allow reasonable investors to build decent long-term track-records. On this dimension as well, there’s an and/or dynamic of madness and wisdom.

So, how to think about markets?

Insanity of markets is more obvious in most times. Pockets of exuberance, cufflinked charlatans peddling crap and wild swings make it apparent. Graham coined Mr Market for a reason. For all of us, keeping this aspect of markets in mind is crucial to not become its slave. Unfortunately, prolonged market insanity makes it hard for us to stay sane. When crap-tech, WFH-plays and crypto went to the moon for years on end, even the best of us had self-doubt. Some of us veered towards the dangerous end of mistaking insanity for sanity. New normal references or new-fangled valuation metrics propped up to legitimize insanity. Even in more sober corners of the market, rationalization was presented for PE multiples higher than my age. Net effect was to lose sight of the other side of markets - sanity, mean-reversion, tether to reality.

Graham is as good a communicator as he’s an investor. There’s a Wodehouseian precision to his turns of phrase. I draw attention to his choice of word in context of markets – mystery. It is an elegant way to describe the fuzzy manner in which insanity gives way to eventual sanity. We don’t know how long it will take or how much sanity will return. In some cases, it may not happen at all. Mystery is less fun in real life than in movies. Waiting uncertainly and uncomfortably, looking bad along the way, unsure if we’re the sane ones, can take us halfway to a padded cell.

2022 was therefore much needed. Precipitous drops work better than pompous essays to drive home a few timeless lessons. Reality matters, as does law, accounting, valuation, cash flow, quality and risk. Hopefully, investors will be more sceptical of the next IPO priced off FY41 projections and 9.42% cost of capital.

Personally, 2022 was nice because the weighing-machine aspect of markets is a matter of faith. Most of the time, it doesn’t seem to hold true. But it better be true for me to show up at work each morning. Much as faith of die-hard devotees isn’t easily shaken, occasional external validation helps. It reminds us to go back to long history as our reference point for judging sanity and insanity.

To close, I don’t know whether the stuff that fell a lot is now at sane or insane valuations. I don’t even know what any of them were worth to begin with. I also don’t know where they are headed, although I wish some of it goes to zero. They are merely exaggerated illustrations of market’s two-faced nature, somewhat more apparent in 2022 than before. However, I do know an approach that helps me make peace with this Schrodinger characteristic of markets:

• Have clear standards to establish what’s sane, preferably based on underlying business, long history and common sense.

• On seeing clear insanity, accept it for what it is. Don’t rationalize it merely because sophisticated strangers are doing so.

• Base investment decisions and expectations on sanity prevailing, not insanity continuing.

• Be mentally prepared for an uncomfortably long periods of insanity, especially of the kind that fosters doubt and regret.

• Keep the faith, as Graham did.

Wishing you a mysterious, paradoxical, confusing, Schrodinger’s 2023.