Value Investing in the "Secondary" Market
Board: Value Hounds
Good discussion, guys. As you argue, and as I realized yesterday as I walked my afternoon miles, what we are calling “the market” has to be partitioned into the “primary market” (where the hustle is run) and the “secondary market” (where the gambling is done).
In the primary market, a company raises capital by selling shares of itself. To the extent those shares are worthless (i.e., have no tangible value other than “hope of future profits” is the extent to which the company has created money. To the extent those shares have value (i.e., could be immediately exchanged for cash), the two parties involved have merely done an exchange, and the total money in the room remains the same.
In the secondary market -- i.e., the market in which most investors do their betting -- all transactions are exchanges of existing values, and wealth is neither created nor destroy, but merely moved from one pocket to another. So, let’s go back to kelbron’s example of a series of sales at declining stock prices and find that “missing” $55. Create a room in which there are kelbron’s nine sellers, each of whom buys high and sells lower, creating a series of losers until the stock price bottoms. If the selling started at $90 and ends at $35, it seems as if $55 disappeared. Seller One (who bought at $100 and sold at $90) lost $10. Seller Two (who bought at $90 and sold at $80) also lost $10. But the stock IPO’d at $10. On the way up to the market top at $100, Buyer One sold at $20 to Buyer Two, who sold to Buyer Three at $40, who sold at $100 to the guy who became Seller One. In other words, once the initial scam is put into place, winners offset losers, and losers offset winners, making all subsequent transactions a zero-sum game.
But there’s yet a further complication. You don’t have just a roomful of investors betting with each other. Like one of those Russian nesting dolls, you’ve got rooms within rooms within rooms, in which railbirds are betting on the action at the table in the inner-most room, and railbirds in the second room are betting on the railbirds in the inner room, and railbirds in the room that encloses that are making bets, without there being an upper boundary to the how money flows into and out of the total set of rooms.
But whatever the true existential situation might be in terms of how/whether wealth is created/destroyed, here’s the true point of this discussion. At the level of retail investing, in which Joe and Mary Average are putting capital at risk in hopes of gaining profits, if they set aside the myth of “an expanding pie” and focus just on the task of pulling more money out of the game than they are bringing to it, they are forced to think about the bets they are making as bets, and they can avail themselves of the abundant literature on how to size those bets, so at to be able to stay in the game long enough to learn the game.
That’s why I frame investing as a less-than-zero sum game. Those who believed the “stocks for the long run” pied-pipers got killed in the 2008-2009 correction, and they still haven’t recovered the money they foolishly bet. But those who knew that investing is merely gambling (i.e., had an investing method based in reality) got themselves back in the game as the market bottomed, and they ended the year in the black.
Think back to the fall of 2008. All hell was breaking lose. (More accurately, excessive leverage was being involuntarily unwound.) The spring of 2009 was no better, and the early months of 2009 continued the trend of falling prices. But at some point, a value-investor --and this is a value-investing forum-- should have said to her or himself. “I’m seeing attractive discounts to intrinsic-value being created. I don’t know that prices won’t go even lower. But it’s become time to start averaging in by making bets I know I can afford to lose. I won’t like losing those bets. But if I’m not willing to put 5%-10% of my capital back to work at this point in the market of where prices are relative to intrinsic-value, then I can’t call myself a value investor. Fish, or cut bait.” Using small, measured bets with an all-bond portfolio, I ended 2009 up 33.6%. 2010 offered two-thirds of that. 2011, one-third. But the trend is clear.
You and a counter-party are making bets with each, and one of you is going to be wrong. Your job is to ensure it is the other fellow. But if it is you this time who is wrong, then the bet can’t have been so big that you get yourself thrown out of the game.
What average retail investors have is lots of hope and zero money-discipline. If they frame the investing game as adversely as they should, maybe, just maybe, they’d begin to look for the tools they need to survive when investing does turn into the raw, brutal, less-than-zero sum game it can become. There’s a study now floating around the web which reports that the median, non-home net-worth (in 2010 dollars) has fallen to a mere $10,000. How do you make investment bets with a mere $10,000? The stuff they should be buying if they want to turn a decent profit is beyond their means to manage the risks of responsibly. So a Catch-22 situation has arisen in which they can’t get ahead, because they now lack the means to get ahead, because they threw away the resources they once had by gambling with them foolishly.
Everyone knows the mantra by which wealth is accumulated: “Buy low; sell high.” But there’s another one that’s even more important: “Bet widely; bet small."
The Asset Price Meltdown and the Wealth of the Middle Class by E Wolff http://appam.confex.com/appam/2012/webprogram/Paper2134.html...