In addition to laying the groundwork for value investing, Ben Graham gave us a vivid metaphor that has been recycled and re-imagined by value investors including Warren Buffett and Seth Klarman ever since: Mr. Market. In his latest white paper Michael Mauboussin, managing director and head of Global Financial Strategies at Credit Suisse, finds that Mr. Market is still a useful way to think about markets, but his extreme mood swings don’t happen at random, they’re caused by a lack of diversity.
Value investors have to agree with both Shiller and Fama, says Mauboussin
“To be an active investor, you must believe in both inefficiency and efficiency. In other words, you have to think that both Shiller and Fama are right?just not at the same time,” writes Mauboussin.
He argues that most of the time Mr. Market is reasonable, the prices that you have to choose from are a good estimate of a company’s actual value, and those estimates have mostly improved over time. He uses the standard deviation of excess returns to illustrate the point, but it’s not surprising considering how many more people are involved in finance and the computational tools they now have to work with.
Mauboussin also argues that value investing works and that you can see it because cheap stocks have outperformed growth stocks over the last 90 years or so (though not continuously – there are plenty of shorter periods when growth stock do better).
So the question is why the market, which is usually efficient at setting prices, is occasionally very far off the mark. Mauboussin rejects the classical assumption that investors are rational, but he also argues that there are limits to the more nuanced view that a small set of arbitrageurs are able to keep prices in line with value when the rest of us get it wrong. There have been plenty of occasions (he uses the collapse of Long-Term Capital Management) when arbitrageurs were nowhere to be found while the system is under stress.
“Here’s the key: The wisdom of crowds only works under certain conditions, which include diversity, aggregation, and incentives,” writes Mauboussin. “Given that we are social beings, it is not surprising that the condition most likely to be violated is diversity. Rather than operating in a diverse fashion, we correlate our behaviors. And stock prices themselves contribute to the process of correlation.”
The non-linear relationship between diversity and stock prices
The other two conditions are almost always going to be met in the stock market: information is constantly being aggregated and disseminated to market participants, barring a technical failure of some kind, and the incentive to beat the market doesn’t need any explanation.
Diversity, by which Mauboussin means a mix of fundamental traders and technical analysis, different investment horizons, and all the other biases people carry with them into trades, is another matter. He points to the work of Brandeis University economist Blake LeBaron who has modeled the market as independent agents, all of whom use basic portfolio theory and reasonable trading rules, and still comes up with the kind of crowded trades and irrational spikes that we see in real markets. Too much diversity in opinion is what pushes Mr. Market over the edge, and it’s what value investors should be looking for both to protect themselves and to find opportunities.
See full PDF below.