It is a recurring and decidedly unfashionable theme here on Going Private that crowds tend to be dense, rather than enlightened. Naive rather than insightful. Shallow rather than penetrating. I make this observation with no relish and though I would that it were not so, all the personal experimental data I have bears it out (even if the statistician in me worries with constant whisperings in my ear that this represents rather a small sample size).
One of the appeals of the private equity world, at least for me, was that success in the field required what one friend of Going Private would call "deep thinking as a prerequisite for action." That is, that a fundamental understanding of the underlying dynamics of the business and the finances surrounding the business forms the foundation for the decision to proceed with a transaction, how to proceed with a transaction and what to pay in a transaction. From there, insights into the business drive how it should be transformed, and those assumptions feed right back into what it is worth paying for the business.
By definition, successful buyouts require a contrarian demeanor. "Contrarian," in this context, is, I believe, a gentle euphemism for "arrogant." Contrarian investors think the crowd is full of barely useful idiots. They think the street has it wrong and they are just pig-headed enough to put their money where their mouth is. "You sheep are all fools," they might say to themselves, "and I will fleece you for it." It is this force of personality, this unbridled self-confidence that makes the hallmark of a good contrarian.
Amongst these I divide the field into two. First, the thoughtful, deliberate contrarian. The against-the-current investor who has armed herself with research, background and who has a method, even a mad one, that underlies their investment thesis. Second, the rash contrarian who relies more on instinct and force of will than well structured, deep argument supporting a thesis. To my way of thinking the Emperor of the Rash is personified in Steve Jobs. Let's call this, henceforth, the Jobsian School of Contrarian Thought. Consider this bit from New York Magazine:
When Jobs prepared to launch the first iMac, he was confronted by underlings who told him he was crazy: Every shred of market research had concluded that consumers wouldn't buy an all-in-one computer. Jobs shot back, "I know what I want, and I know what they want."
...the most common descriptor applied to him, by friends and foes and even Jobs himself, is "asshole." (Running neck-and-neck for second are "genius" and "sociopath.") His abrasiveness is legendary and omnidirectional. Asked by a writer from Wired, "If you could go back and give advice to your 25-year-old self, what would you say?," Jobs erupted, "Not to deal with stupid interviews, I have no time for this philosophical bullshit!" Given an early glimpse of the Segway high-tech people-mover, he bellowed, "I think it sucks," then later called the company's founder, trashed his CEO as a "butthead," and said his marketing chief "should be selling Kleenex at a discount store in Idaho."
Exploring why contrarian strategies are successful presupposes some thesis regarding the foolishness of crowds. I submit that success as a contrarian requires one of two conditions. Either that the crowd is fundamentally wrong in some respect or that the underlying conditions crowds are reacting to can be altered in a meaningful way. The later, I suspect, is both rarer and more likely to benefit followers of the Jobsian School of Contrarian Thought.
Says New York Magazine of the changing nature of the information revolution that brought Apple back to prominence:
No longer were people using their machines just for serious stuff, documents, spreadsheets. They were using them for purposes that were purely recreational. E-mailing. IM-ing. Downloading purloined music. Devouring online porn. And once the PC entered the realm of fun, it became a province of fashion.
But I think this backwards. I think it was the likes of Jobs, and others, who drove computing into lifestyle use rather than professional pursuit. "I know what they want," in Jobs' words. If this is true than it quickly becomes apparent that it might be more accurate for Jobs to have said "I know what they will want." It should be equally obvious how much of an uphill battle this sort of contrarian success is likely to be and why massive egos, the kind that trample over disagreement with a certainty that may defy logic, are a prerequisite to this sort of success. "If the data doesn't support the theory, change the data," might well sum up this approach. Why is it that these mavericks, despite the profane labels we might assign them, are politically more correct than the thoughtful, dogmatic contrarians?
The less sexy but, to my way of thinking, more intellectually pure contrarian approach presupposes something else. It presupposes that the data is in there, somewhere, to support the thesis, but it is either too obscure or has not yet been effectively collected by the crowd to be priced into the market. I am predisposed to find this much more compelling and accessible an investment approach because it does not require the same force of personality or cult of personality to effectuate. Rational actors will be receptive to the theory when presented because its foundation is one based on evidence, rather than will. As Armin might quantify this sort of persuasive discussion: "Present the current state of affairs. Present the inefficiency embedded in the state. Explain the problem that has thus far prevented a correction of the inefficiency. Present the new development that now permits the correction."
Consider the discussion I framed yesterday about credit markets as an example:
The current state of affairs is a credit market environment characterized by historically low, shockingly low, prices for credit. The inefficiency is that defaults are not being priced into the market. The problem keeping this inefficiency from correction is that incentives are aligned against actors allowing default information to be priced into the market, either because of the depth of their derivatives and exposure to same or because it is trivial to shift losses away from mortgage backed securities into other entities. The new development is increasing market awareness (perhaps through presentation by us) of the accounting and derivatives structures that expose pricing inefficiencies in the credit markets.
An amazing amount of clarity can be introduced into investment theses just by framing the problem in this fashion. This, in my view, is the essence of deep thinking as a prerequisite to action, the foundation of my approach to contrarian investing, and why I love buyouts.
For all the talk about the "Wisdom of Crowds," or the "miracle of aggregation," it isn't hard to see how crowds can get it wrong, and often.
The Economist chimes in with a review of some recent research on the nature of crowds in the form of voters (and, for the alarmist, an implicit prediction of the approaching death of democracy and capitalism). One might summarize the piece best with the phrase: "Crowds are dangerous."
The "Wisdom of Crowds," is based upon the general case that "...if ignorant voters vote randomly, the candidate who wins a majority of well-informed voters will win." This is why "prediction markets" tend to work, why futures markets are good sentiment indicators and why markets tend to price assets reasonably (usually). But several flaws creep into this general case making for a specific bunch of exceptions. Says the Economist of the case with voters:
[There are] four biases that prompt voters systematically to demand policies that make them worse off. First, people do not understand how the pursuit of private profits often yields public benefits: they have an anti-market bias. Second, they underestimate the benefits of interactions with foreigners: they have an anti-foreign bias. Third, they equate prosperity with employment rather than production: Mr Caplan calls this the "make-work bias." Finally, they tend to think economic conditions are worse than they are, a bias towards pessimism.
Mr Caplan gives a sense of how strong these biases are by comparing the general public's views on economic questions with those of economists and with those of highly educated non-economists. For example, asked why petrol prices have risen, the public mostly blames the greed of oil firms. Economists nearly all blame the law of supply and demand. Experts are sometimes wrong, notes Mr Caplan, but in this case the public's view makes no sense. If petrol prices rise because oil firms want higher profits, how come they sometimes fall? Surveys suggest that, the more educated you are, the more likely you are to share the economists' view on this and other economic issues. But since everyone's vote counts equally, politicians merrily denounce ExxonMobil and pass laws against "price-gouging."
Consider also the implications in conjunction with this quote, oft (and erroneously) attributed to Alexander Tytler:
A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largess from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury with the result that a democracy always collapses over loose fiscal policy, always followed by a dictatorship. The average age of the world's greatest civilizations has been 200 years.
For a rather detailed discussion on the surprisingly miasmal origins of this quote, Loren Collins has a great piece that will interest the always intellectually curious Going Private reader. If nothing else, the mysterious origins of the quote also have the rather depressing effect of confirming just how much easier it is in an age with massive interconnectivity for "fact" to be supplanted by effective rumors.
Going Private readers are likely to have already dug through numerous used book shops to find a copy of the outstanding and, unfortunately, out of print work "The Psychology of Rumor," by Gordon Allport and Leo Postman. Allport and Postman's "Basic Law of Rumor," that "rumor strength" [R] will vary with the importance of the subject to the individual concerned [i] times the ambiguity of the evidence pertaining to the topic at hand [a] or "R = i * a," will cause naturally cautious Going Private readers to immediately understand the counterintuitive import of the fact that ambiguity in evidence strengthens a rumor.
Regardless of the mystery of its birth, the quote's message may be a bit alarmist, and the market often works mightily to correct political missteps, but, I lack confidence in the power of the market in the face of the new and celebrated value of ignorance (more than half the United States believes Elvis is still alive) and what we have only recently discovered about cognitive biases. More than sixty are outlined in a Wikipedia entry on the topic.
Moreover, contrarians who profit by their clever investment theses are often vilified in the public and have recently become the target for everything from taxation and regulation to outright legislative prohibition. I am convinced this is because a powerful streak of envy runs through Western culture with respect to finance in this age. Friedman was fond of pointing out that both envy and emotional notions of "fairness" often led to measures, particularly legislative, that did more harm than good to the very classes that the "do-gooders" professed to help. The minimum wage was an oft cited example but certainly public education has been a much clearer case. We need only to look at the latest craze for philanthropy to see why the likes of Bill Gates would decide to gift his wealth to countries crippled by years of development stifling, extraction model economies despite the fact that turning these same funds to capitalist endeavors would almost certainly result in many, many times the utility.
I have commented in these pages before (albeit humorously) about the strange schizophrenia Western capitalist systems seem to exhibit with respect to capitalist successes. Nowhere is this more pronounced than in the vilification of the deliberate contrarian. The man who made his fortune by exiting at the top of the bubble market is a clever, lucky hero. The man who managed to profit famously in the stock market while others threw themselves from buildings during the crash must be a unrepentant, morally depraved cad. (But really, do we as a society want to prefer Mark Cuban to Benjamin Graham?)
What does it say that clinging to baseless theories in the face of all evidence has somehow become a sign of inner moral strength? It becomes quite hard not to view the "struggle of our time" as one between knowledge and ignorance.
And even if one sides with "knowledge," one must do so with the awareness that our models for describing the world around us are, almost by definition, fraught with error and flawed. When was the last time someone predicted the weather right 7 days in a row?
The class warfare and the envious mewing over "income inequality" has gotten so thick that one can feel it as mist on the skin as one walks through markets. It causes one to wonder: If hedge funds are the "Galapagos Islands" of investing, and buyout funds the last salvage hope of ruined industry, what if we demonize them, by virtue of their success, into extinction?
I want to take comfort in Churchill's quote to the effect that democracy is "the worst form of government, except all those other forms that have been tried from time to time," but the crowds look quite dangerous and riled. It is a dangerous thing to be a wolf just now.