Greater Fool Theory by SG Value Investor, The Value Edge

The Greater Fool Theory states that the price of a good is not determined by its intrinsic value, but rather by irrational beliefs and expectations of market participants. Essentially, it is about buying a good at a price then offloading it to the next fool at a higher price. This vicious cycle would continue till the point where market participants ‘wake up’ and realize that the good is no longer worth that value. The best example would probably be the tulip mania where the Dutch were trading houses and lands just for plots of tulips. As absurd as it may sound, back then even the most rational were engaged in such madness. With such irrational beliefs and expectations of the market, it would ultimately result in a ‘bubble’.

You only find out who is swimming naked when the tide goes out – Warren Buffett

What does it mean for investors?

Undoubtedly, companies like UOB-Kay Hian Holdings Limited (SGX:U10), DBS Group Holdings Ltd (SGX:D05) (OTCMKTS:DBSDY), Keppel Corporation Limited (SGX:BN4) (OTCMKTS:KPELY) etc. trading at current valuations are justifiable given their solid earnings and fundamentals. However, what of other companies that are trading at high PERs and EV/EBITDA? I feel that companies that fall under this second category can be split into three further sub-categories.

Firstly, it would be those that lack the fundamentals and earnings. These companies are constantly raising additional capital from the market, where management attempts to keep the sinking boat afloat. Companies that fall under such a scenario are trading at high valuations due to investors buying the turnaround story. Indeed, if  successful, huge capital gains can be expected. On the flip side, they could lose everything too.

Secondly, it would be companies on a growth surge having perhaps tapped into an emerging market like China or India. Such companies would definitely have the earnings and fundamentals to support a higher PERs and EV/EBITDA than normal. However, the crux is what is normal? Where do we draw the line? Given how each individual investor has a different definition of fairly valued, it would just be a case of buy high, sell higher. Many a times, the run up in valuations would no longer be in tandem to the growth of the company, commonly known as a ‘false dawn’. Such as a couple of years ago, we see Apple Inc. (NASDAQ:AAPL)’s share price constantly breaking new records. I continuously saw analysts revising their target price, from $500 to $700 and even to $1,000. While Apple is a great company, does it truly justify such a target price? Just one earning’s miss and everything comes tumbling down like a house of cards.

Lastly, it would be a scenario where the company reported great news. Investors would begin forming lofty expectations. One year ago, there was this craze over companies having managed to enter the Myanmar market. The key here would be ‘having managed’. Whether it would truly translate to tangible benefits for the company is still an unknown. Last June, when the news reported that two of NeraTel’s clients managed to enter the Myanmar market, many investors started forming expectations that NeraTel would be able to benefit from this. The share price shot up by approximately 31.7% within a few days, ultimately pulling back. Hence, as the old saying goes, ‘The greater the expectations, the greater the disappointment’.

Conclusion

With investing, there is no shortcut. With every stock, do your due diligence and not base your buy/sell call on someone else. With regards to news, analyse it rationally and not let your imagination get ahead itself. Last but not least, be objective. There are many great companies out there. However, ask yourself if the price is truly justifiable or are you just getting sucked into a case of a buy high, sell higher. After all, none of us would ever want to be caught swimming half-naked when the tide subsides.

Disclaimer: The authors have no vested interests in above-mentioned stocks