The
traditional view of investing held that securities should be purchased at a
discount to their true worth or "intrinsic value." � Modern financial theory,
on the other hand, maintains that markets are "efficient,"� meaning that
security prices reflect, in a rational manner, all information that might be
relevant to determining an issuer's worth. If the latter assertion were, in
fact, correct, then how would investing as traditionally conceived be
possible? How could discounts ever appear when thousands of observers,
analysts, and market participants are constantly digesting every bit of
data, all contributing in real time to the price discovery process? A cynic
might respond that an assumption of market efficiency is required in order
for the statistics underlying modern financial theory to work (we admit to
sympathizing with this view). The fact remains, however, that markets are
usually quite good at quickly responding to information flow and adjusting
prices accordingly. Hence, it is normally very difficult to find worthwhile
discounts — �ones that persist long enough for the slow-speed trader to take
advantage of, and of a sufficient depth to attract the traditional
investor's interest. Nevertheless, discounts do appear from time to time,
and for reasons that are rooted in the nature of financial markets, as
opposed to financial theory.
Most of the time the community of investors and their enablers (brokers,
analysts, bankers, etc.) operate within a world of efficiency and rough
"equilibrium,"� to employ a term dear to economists.
Decision-makers allocate capital, analysts analyze, and bankers promote
securities, all relying on an assumption that a recognizable sort of
normalcy will prevail in the future, permitting growth and earnings
projections to be met (roughly), businesses to dive or thrive, and demand
for new products to appear. In other words, the present will more or less
continue into the future and impact it in predictable ways. Note that this
stance is to a very large extent backward-looking. As the military
prepares "for the last war,"
according to the common expression, Wall Street looks forward to the last
financial crisis. Hence, as a result of the 2008-09 experience, in this
world even "black swan"
events (a term which became popular during the crisis, it
refers to the out-of-left-field, unexpected, and unpredictable occurrences
that upend the normal state of affairs) have become "normal"�
in the sense that they are identified, discussed, and warned against.
Investing, for the most part, becomes a routine search for "growth" or some more or less
temporary business advantage.
As a great
investor once observed, markets change, but human nature stays the same. So
when the world acts in unexpected ways, things get truly interesting. Whether it is due to the appalling collapse of the U.S. real estate finance
system in 2008, unforeseen consequences of "portfolio insurance"
in 1987,
or, in the case of an individual company, the Tylenol tampering crisis at
Johnson & Johnson in 1983, uncertainty triumphs over reason, and
expectations change radically. On Wall Street, earnings projections become
meaningless, and neat predictions about the future prove unrealistic (they
almost always are anyway). Far from being rational, financial markets can
react violently at such times as they are pummeled by the fears of their
all-too-human participants. Securities prices, especially for equities,
usually suffer, as their valuations had become elevated during times of
stability.
Disruptions
are also characterized by extreme shortsightedness as participants seek to
preserve capital under fearful circumstances. "Efficiency"�
becomes overwhelmed by emotion. For the investor, who by definition shuns
emotion and takes a long-term view concerning values, genuine "discounts" appear.
While markets may "abhor uncertainty,"� as the saying goes, investors love
the discontinuity that follows in its wake.
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