Tuesday, March 21, 2006

Stocks and humans 3 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
Nature is driven by immutable laws, and is considerably more black-and-white than humanities and the arts, which is driven by human perceptions. Seen in this light, it is not too far-fetched to compare stocks to humans, for two reasons: firstly, the companies behind the stocks are run by human beings with their distinctive human weaknesses and tendencies; and secondly, the prices and liquidity of the former are set by the latter, and are influenced by human perceptions of the value and prospects of the parent company.

Why do some stocks remain stagnant for long periods despite apparently compelling value, while others consistently remain market favourites and trade at high PEs which apparently overvalue them? One has to accept that value of a company franchise is a function of perception; in the same way that a person who can market himself and his skills better gets the job or the girl, the stock which is well-covered by brokers and institutionalised becomes a perpetual market favourite. And the beauty (or unfairness) of this process is that the cycle is benign: the more popular the stock, the better valuation it commands which means the company can easily raise funds from the market for further growth, in the same way that the successful professional builds upon his experience to grow his career exponentially. My feel is that without the marketing efforts from brokers (analyst coverage etc), the stock market would probably trade at half its current PE (for evidence, just look at the typical acquisition of private companies, which are usually valued at low PEs and/or close to NTA valuations); so you see, brokers serve a role in society!

As in real life, there are people who prefer the hot favourites and those who look for the undervalued. In stock markets we would call them momentum traders (follow the price trends!)/growth investors (typically high-PE stocks) and value investors respectively.

Ceteris paribus, the individual with the skillsets in the hottest sectors will command the highest remuneration and prospects. In the 1980s the hot jobs were engineering and construction professionals, in the early 1990s stockbroking was hot, in the late 1990s IT came into vogue on the back of Internet mania. Stock prices mirror such euphoria in the economy, with hot sectors and themes bringing the most rewards to the stocks in that particular sector.

And that brings us to one particular point characteristic of humans and by relation stocks: their tendency to move in up-and-down cycles. The individual who has achieved a measure of success develops complacency or hubris, takes excessive risk and suddenly things come crashing down. Extrapolate this to companies and one can see the direct relation to stocks. The second way in which a cycle develops is through the business cycle, where high demand is followed by excessive investment to fulfil that demand which in turn leads to declining margins and pains for all involved. There are so many examples of manias followed by panics in history to prove the point, with the most recent ones being of course the dot-com mania and the 1997 Asian financial crisis which was preceded by rampant property speculation. Excessive optimism and pessimism defines human nature and by extension, stock prices.

In personal and business transactions, the most important quality people look for is integrity and sincerity. Surely one should extend this to stock investment. That is why most top investors, like Warren Buffett, emphasise the importance of honest and shareholder oriented management, more than anything else. My opinion is that if one extends his understanding of humans (which he is obviously more familiar with) to his views on stocks, he will be able to manage his risks much better.




Anonymous Anonymous said...

Hi Daniel,

I have been reading your blog and must say I thoroughly enjoy it. Insightful and very well-written.

My question to you is: don’t you think that the reason why some stocks gain superb momentum is also due to word of mouth communication?

In my opinion, the influential power of word-of-mouth communication is growing in business. Especially new communication tools such as message boards, blogs and other online sites influence our decisions on what we buy, what we invest in and influence our thinking about a company.

I know you have briefly touched upon this issue (online forums) but I would like to read more of your thoughts, regarding word of mouth and the influential power of blogs.

3/21/2006 3:47 PM  
Blogger DanielXX said...

I'll see what I can do :-) Cheers for your support.

3/22/2006 5:16 AM  

I do not think the two go together.

12/11/2012 4:24 PM  

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