Why Buffett Won His Bet Against Hedge Funds

QE had a lot to do with it.

Active fund manager billionaires Warren Buffett and Charlie Munger have been critical of active fund manager millionaires for their very high fees and chronic underperformance. It is not unusual for the ultra wealthy to trash the merely wealthy for their avarice. After all, ultra wealth is so rare that it can be seen as an act of God, whereas mere wealth is the product of human toil and vanity, arduous and earthly.

Buffett and Munger are all-in on their recommendation that investors should dump active strategies and instead invest in passive indexed mutual funds or ETFs that simply mimic the S&P 500. Although this is a popular line among many seasoned investors, it has been getting long in the tooth and has turned what was once a good idea into a crowded trade, with hundreds of billions of dollars shifting from active to passive.

In our view, Buffett’s advice represents last year’s thinking. This year’s thinking, we argued previously, should be that passive funds are merely free-riding active funds and that past a certain market share, passive strategies will bite investors as badly or worse than active ones. Continue reading at Seeking Alpha >>>

To Save or Ruin Twitter

A decision that could fix Twitter or hasten its demise.

This is not the first article to suggest that Twitter can generate some revenues by charging its users, but perhaps we can offer some new angles to the discussion. To begin, it is helpful to differentiate between the different types of Twitter users. These seem to be:

  • Media firms publishing their stories and videos, for example CNN, the New York Times, etc.
  • Corporations marketing their products or making announcements.
  • Non-profit organizations and NGOs raising awareness on various issues.
  • Government institutions, agencies or individuals trying to inform the public.
  • Famous individuals looking to communicate with their fans, for example celebrity entertainers, politicians or opinion leaders.
  • Public or semi-public individuals looking to raise their visibility and to build their personal brand, for example journalists, consultants and academics.
  • Small or mid-sized businesses promoting their services and products.
  • Private individuals seeking a mode of expressing their thoughts and feelings, often anonymously through a pseudonym.
  • Private individuals who rarely or never tweet but visit Twitter frequently to read the news or other people’s tweets. Continue reading at Seeking Alpha >>>

Passive Funds Are Just Free-Riding Active Funds

If you and your neighbor have the same income and expenses except that he rides the bus for free every day while you pay a fare, he will be richer than you. Until recently, this was obvious: the neighbor is a free rider while you pay your way.

But now, the obvious is presented as a novelty. Plenty of people are extolling the benefits of free-riding without naming it as such and encouraging a large exodus from active to passive (or indexed) funds. The only problem is that proponents of this form of free-riding neglect to also mention the following corollary sub-plot.

Now your neighbor makes you feel like a fool and convinces you to also ride for free. Soon, your whole town has caught on to the idea and fewer and fewer people are willing to pay for the bus. After a while, the number of people supporting bus service with their dollars becomes so small that buses go out of business or fall into a state of disrepairContinue reading at Seeking Alpha >>>

The Way Forward for Hedge Funds – 2

In the first installment, I made a case that hedge funds can regain their popularity by reverting to their initial mandate which was to be hedged. I examine here how such a model hedge fund would have performed in the past 50 years if it had returned:

  • 0% in all years when the market was down.
  • 75% of the market gain in all years when the market was up.

In essence, this fund only has a chance of outperforming the S&P 500 in the long run if the market has a big down year (say 10%+) every few years.

So what do the past 50 years tell us? Read more

The Way Forward for Hedge Funds – 1

Hedge funds should go back to hedging and also consider lower fees.

Equity hedge funds are under tremendous pressure, having underperformed their benchmark in nearly every year since 2008. But can it really be true that the average equity hedge fund is no better over the long run than granny’s passive indexed ETF or mutual fund that tracks the S&P 500?

On one side, hedge funds employ full-time cohorts of smart ambitious highly credentialed people who spend long hours and a lot of money visiting and analyzing companies to find the best opportunities. They sit in beautiful new offices and use the latest in real-time data feeds and state of the art technologies. Read more

Ratio of Gold to S&P 500

(Chart updated on 30 November 2015 with ratio at 0.51)

The ratio of the price of gold to the S&P 500 shows two notable extremes that are clearly visible in the log-scale chart below. The first was a reading of 6.1 in January 1980 when gold spiked up to $850 per ounce and the S&P 500 was struggling to shake off the 1970s syndrome of “death of equities”, “misery index” and “malaise”. The second was 0.19 in July 1999 and subsequent months when gold hit a multi-decade low of $252.8 while the S&P 500 soared on the wings of the Nasdaq bubble.

A more recent high of 1.5 was in September 2011 when gold reached an all-time high of $1,895. The ratio has since retreated to 0.56 today which is a level not seen since the stock market highs of 2007.

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It should be noted that the average for the ratio, since gold started trading freely in 1968, is 1.18, which means that it is now well below the average. Reversion to the mean here would mean the S&P 500 falling by half or gold doubling, or various combinations such as for example the S&P 500 falling by 35% while gold rises 35%.

There is no doubt that there is some exuberance in the stock market, but it does not necessarily follow that the ratio should quickly revert to its long-term average. After all, one may ask, why is this ratio even relevant? It is a question that is justified if you believe that gold should only reflect inflation expectations. Then it would rise or fall with inflation fears.

But in reality, there is more complexity in what drives the price of gold. Inflation numbers were similar in the 1990s and 2000s but gold fell in one decade and rose in the other. Therefore, inflation alone is not enough to explain its behavior.

What drives the price of gold will be the subject of another post. But here it is enough to say that it is driven in part by several factors which are the inverses of those that drive the S&P 500. It makes sense therefore to keep an eye on the ratio.

Keurig Green Mountain: Overpriced Coffee and Stock

20 November 2014

From a press release on 14 August 2014:

Keurig Green Mountain, Inc. (NASDAQ: GMCR), announced today a price increase of up to 9% on all portion packs sold by Keurig for use in its Keurig® brewing systems and on all its traditional bagged, fractional packs, and bulk coffee products. This price increase will be effective beginning November 3, 2014.

According to Dr. Travis Bradberry, author of Emotional Intelligence 2.0, caffeine boosts your adrenaline level and “adrenaline is the source of the “fight or flight” response, a survival mechanism that forces you to stand up and fight or run for the hills when faced with a threat.”

So Keurig has opted to fight any threat to its margins. It will not be easy.

Until now, Keurig’s profit margins on K-Cups have been very attractive. Profits from the Keurig coffee machines are probably small or nonexistent, which means that the EBITDA margin on coffee alone is higher than the 24% group-wide EBITDA margin. And within coffee, the margin on K-Cups is higher still, which explains GMCR’s 5x price to sales ratio and its $23bn market cap.

The problem going forward is that competition will only increase, putting pressure on market share and on margins. I sum it up through three main headings: K-Cups, Machines and Nestlé.

K-Cups

If you collect enough coffee from K-Cups to fill a one-pound bag, you will have spent anywhere from $25 to $50 in K-Cups. That could be well over twice the retail price of bagged coffee, which itself already enjoys a hefty markup.

Put another way, if I prepare my daily coffee using K-Cups and a Keurig machine, it will cost me anywhere between 60 cents to over a dollar per cup. But if I buy bagged coffee and EZ-Cup Filters, it could cost me say 25 cents for the coffee and 10 cents for the filter, all together about half the less pricey K-Cup option. The bottom line is: coffee sold in K-Cups costs a lot more than the same amount of coffee sold in bags (to do the math, 1 pound = 453.6 grams).

In this photo taken at a coffee shop, the same brand coffee is selling for $13.95 per pound and for $11.95 for a box of 12 K-Cups, each weighing 12.9 grams. Pound for pound, the K-Cup coffee costs 2.5x the bagged coffee. Some premium is certainly justified for processing, grinding and packaging K-Cup coffee, but 2.5x looks like a very generous markup.

This large price difference creates an opportunity which puts Keurig margins at risk. If I were a manufacturer instead of a consumer, I could buy coffee wholesale for less than 25 cents per 10-gram serving (the amount of coffee in most K-Cups appears to be in the 9 to 12 gram range), put this coffee in compatible cups or filters and sell it at a tidy profit while still undercutting Keurig prices. The large Keurig markup means that there is ample room for competitors to enter at various price points and still derive a profit.

None of this has gone unnoticed. As many as 14% of K-Cup compatible pods have come from private-label suppliers (other estimates are closer to 10%). The remaining 86% come from Keurig’s own brands and from Keurig licensees (Starbucks SBUX, etc.). Keurig believes that the 14% will decline and that the 86% will grow. But the opposite is just as likely because competition does not usually decrease when margins are large for a product which is being progressively commoditized.

There will certainly be more competition at lower price points in single serve units whether they are called K-Cups, pods, capsules, or something else. This company for example offers tiny suppliers (as small as individual coffee shops) the opportunity to package their coffee into Keurig compatible cups, starting with very small volumes. Going forward, one could buy single serve cups from Keurig or a Keurig licensee or buy them from a favorite coffee shop at about half the price.

In this vein, I am reminded of an interview with Harvard Professor Clay Christensen in which he discusses Apple’s success within its own ecosystem. You could substitute Keurig for Apple in the following quote and it would make sense:

In the end, modularity always wins… You can predict with perfect certainty that if Apple is having that extraordinary experience, the people with modularity are striving. You can predict that they are motivated to figure out how to emulate what they are offering, but with modularity. And so ultimately, unless there is no ceiling, at some point Apple hits the ceiling.

Granted this is long-term theory. In the near term, as the good times continue, Keurig can be described as a marketing rollup. In a traditional rollup, a company grows by acquiring several of its peers sequentially over a period of years. It brings its expertise and economies of scale to its acquisition targets and benefits from their improved profitability. In a marketing rollup, a company convinces several of its peers to join its platform by promising to sell their product at a higher price and splitting the benefits with them. Keurig has clearly been masterful at deploying this strategy, selling its own and third-party coffee at a premium.

Keurig has also been masterful at announcing new partnerships frequently and methodically, in a way that has so far been hugely beneficial to the stock price. There is a measure of genius in this management who have not only convinced millions of Americans to pay more for coffee in return for some convenience, but who have also convinced investors that new technology can make a huge difference in the erstwhile mundane task of preparing a cup of coffee. This explains why Keurig’s stock is today very near its all-time high.

Machines

A visit to Bed Bath & Beyond’s website shows that there are now several competing single-serve coffee makers on the market. Some of them like Cuisinart, Mr. Coffee and Hamilton Beach use K-Cups. Others like Nespresso use different capsules. You can now bypass Keurig machines and Keurig coffee brands by buying another machine and by using private label cups. You can choose, from a growing number of alternatives, to enjoy a single-serve cup of coffee delivered with the convenience of a K-Cup (or similar pod) without paying the Keurig company a single dime.

The notion that Keurig can reverse this trend is, in my opinion, unrealistic. Still, the company is giving it a good try with the Keurig 2.0 machine. It includes a carafe and some proprietary technology which will only work with Keurig-approved K-Cups. This means that an unlicensed K-Cup does not work in a Keurig 2.0 coffee maker. A key question for the future is whether Keurig’s market share in K-Cups will erode further or whether it will reverse and trend back towards 100%.

I expect that it will erode further. The restrictive Keurig 2.0 is in theory a good attempt to rebuild the walls surrounding Keurig’s ecosystem, but it does not appear to offer the consumer something truly new and exciting. It does offer the ability to brew a single K-Cup and/or larger batches into a carafe but this is something a consumer can already do with a traditional coffee maker sitting next to a K-Cup machine (made by Keurig or someone else).

Keurig says that a large number of US households have not yet switched to single serve and that their main reason for staying away is that single serve machines do not brew large enough batches of coffee. This may sound like circular logic to justify a plateauing in single serve penetration, but Keurig believes that there is a broader target market for a machine that offers the convenience of both the single-serve and the larger carafe bundled in one product. Except for saving a small area atop the kitchen counter (not an issue in most American kitchens), it is not clear what the consumer is getting in the bundled product that he does not already have.

Notwithstanding the above and judging from the stock’s performance, the market seems to have accepted the success of 2.0 as a foregone conclusion. This may be overly sanguine if Amazon reviews are a good indicator. All three Keurig 2.0 machines available on Amazon have consumer reviews below three stars out of five. By comparison, the older Keurig machines have nearly five stars.

Pricing of Keurig 2.0 machines may be an important determinant of success and needs to be low enough to be competitive with the alternative, which is to own two machines (one single serve, one carafe) for less money and with fewer restrictions than the Keurig 2.0 bundle.

Nestlé

In theory, Keurig has a large potential for expansion outside North America. Today, Keurig’s revenues come from the US and Canada. But the company has recently started to expand into foreign markets, beginning with the United Kingdom. Yet, nothing is as easy outside one’s own home turf. It is not uncommon for a growth consumer company to stumble soon after its entry into a foreign market. In addition, by going overseas, Keurig is entering a world dominated by the giants of global coffee, Nestlé and Mondelez.

They too have ambitions beyond their largest markets. Nestlé is redoubling its efforts in the US. The Swiss company is the world number one in coffee with 22.7% market share, in part because most of the world drinks instant coffee where the Nescafé brand is dominant.

GMCR

Nestlé is already present in single-serve coffee with its Nespresso machines and capsules. Nespresso is dominant in Europe but, in the US, it has lagged Keurig by a long mile because it was slow to adapt to American preferences. Compared to Keurig, Nespresso machines have had higher retail prices and, in the past, have served smaller cups of coffee which are more suitable to the European taste. Although Nespresso has introduced newer machines which can make espresso and larger cups of coffee, it still does not appear to have a product in the US that is designed to take Keurig head on. That could change soon if it is serious about gaining significant share.

We can be confident that competition will intensify here and overseas. But what is of greater importance is the current debate on open vs. closed systems. An open system allows other coffee brands on your machine (for example Starbucks, Dunkin Donuts etc). A closed system does not.

As discussed above, Keurig allows a large number of licensees and a wide portfolio of non-Keurig coffee brands on Keurig machines, all of which bolster the case that Keurig offers an open system. A truly open system however would allow other coffee brands on the machine without extracting a fee from them. So Keurig can be called semi-open (or semi-closed), or open only to the extent that it can obtain a fee from third parties.

Nespresso has been even more restrictive, allowing only Nestlé coffee capsules on its machines. But Nespresso recently lost a ruling in France which forced it to open its machines to other capsule makers. France is Nespresso’s most important market and if Nestlé has accepted that it will run a completely open system in France, it is likely that it will run an open system everywhere. What this means is that there will be more coffee companies making capsules for Nespresso machines. More importantly, it could also mean that these companies can do so without being licensed by Nestlé. If this new openness migrates to the US, it will result in a new headache for Keurig which is trying to remain semi-open (or semi-closed) through its licensing policy and the proprietary technology of Keurig 2.0.

From the point of view of the consumer, a completely open system makes the most sense because it will lead to greater choice, greater competition and lower prices. And as we have seen, prices are high enough that they can fall significantly and still deliver a profit.

Because of its global footprint and large portfolio of brands in other categories, Nestlé could likely sustain pricing pressures in US coffee for longer than Keurig could. Nestlé’s annual coffee revenues dwarf Keurig’s ($16 billion vs. $4.5b) but they amount to less than one fifth of total Nestlé revenues. This is where a large global player like Coke could be helpful to Keurig. But the question remains how much Coke should pay for the rest of Keurig? And when should it make its move?

Coke and Keurig

Keurig stock has been one of the best performers in 2014, in large part due to bid speculation surrounding Coke’s acquisition of a 16% stake in the company. While it is very probable that Coke will eventually buy the rest of Keurig, it does not follow that such a bid is imminent. It could come next week or it could come years from now. Here are the three main scenarios:

1. Coke makes a move fairly soon and offers only a small premium or no premium, arguing that the stock has raced 50% from $80 to $120 and beyond after the acquisition of its initial stake. In other words, the premium is already included in the current stock price.

2. Coke makes a move in a few weeks, months or years at a higher price. By then, the performance of Keurig stock will be largely justified by its own operations and Coke will have to offer a premium to the then stock price. So say that by then the stock is at $170 and Coke will have to offer $200+.

3. Coke makes a move in a few weeks, months or years at a lower price. This could occur if Keurig’s results deteriorate and the stock falls back towards $80 before the bid.

Although investors are excited about scenarios 1 and 2, a trade buyer would normally prefer scenario 3. Why pay $200 per share when you can pay $80 instead? That $120 difference amounts to a $19 billion difference on the current share count.

In February, Coke could have easily bought all of Keurig, given that Coke’s market cap was then over twelve times the market cap of Keurig. The fact that it did not bid on all of Keurig outright could suggest that it viewed the stock as overvalued. Or it could suggest that it needed more time to get comfortable with the prospects of Keurig Cold.

With a choice to act now or wait longer, it may be wiser for Coke to wait longer given the mounting uncertainty facing Keurig. In addition to the competitive challenges discussed above, rising coffee prices could exert further pressure on margins.

Severe droughts in Brazil have resulted in the price of Arabica coffee soaring from $1.10 to $2.10 per pound in the six months to May 2014. It then dipped to $1.60 in June as suppliers sold down their inventories. But the depletion of these inventories boosted the price back to near $2 as of now. The onset of a new El-Nino effect has some predicting a further increase to $3 per pound. Keurig is hedged for 2015, but at higher prices than for 2014. As noted above, it will try to pass on some of these increases to consumers but from $30 per pound equivalent for K-Cups, it is not clear whether consumers will accept the increase or migrate to lower-priced private labels in greater numbers.

Keurig’s rich pricing and margins are not sustainable in the face of rising competition from Nestlé and private label suppliers. Keurig’s management have done an excellent job bringing the company to where it is today. But competitive pressures are mounting and a full bid from Coke is already priced in. At 20x 2015 EBITDA, the stock looks stretched.

This article only represents the author’s opinion, may include unintentional errors, and is not meant to influence the reader’s decision to trade Keurig stock long or short. Do your own work, read more research and draw your own conclusions. If you short the stock, you should be cognizant that 1) Keurig has been very adept at boosting its stock price despite declining revenue growth and 2) a full bid from Coke could come at any time.

Facebook in a Perfect World

24 July 2014

Using Google as a comp for future growth and valuation.

Last Thursday, Jim Cramer compared Facebook (FB) to Merck (MRK). According to this Seeking Alpha report,

Cramer compared Facebook to the early days of Merck, when many were skeptical about the value of the big pharma company. Some declared Merck “the most overvalued stock on Earth,” because its valuation surpassed that of General Motors (GM). Cramer had to face angry clients when his hedge fund held Merck, but his call ended up being a winner; Merck’s products ended up becoming the biggest blockbuster drugs of all-time.

(…)

Facebook has real earnings. Cramer thinks FB could earn $3 per share for 2016, and it has 60% growth. This means it should trade at $90, a 30% premium to where it is currently trading. CEO Mark Zuckerberg outlined a multi-year growth strategy. Cramer thinks it is “preposterous” that FB is that cheap. A couple of years ago, FB had no mobile strategy, and now it is the “king of mobile.” User-generated content is good for gross margins and for advertisers. Facebook may be one of the most lucrative stocks of the era.

Generally, the business model and operations of Facebook have little in common with those of Merck. But even if Merck and Facebook were similar in some ways, it would still be possible for Cramer to be right about Merck back then and less right about Facebook today. As to Facebook’s valuation, a stock price of $75 may be cheap when we look back years from now, but only if the intervening years deliver on today’s more bullish forecasts. A long-term promise is not as good as a near-term projection. And on this and next year’s metrics, the stock certainly looks richly valued.

I mention Cramer to make a point about the way investors influence each other’s decisions. I wrote recently that, because investors and traders influence each other, for example through shows like Cramer’s Mad Money or articles on Seeking Alpha or other platforms, large cap stocks like Facebook and Apple (AAPL) could at times be mispriced by very wide margins of 20%, 30% or even 50%+. We certainly saw how this could be the case in the bubble of 1999-2000 and again in 2006-07. And we are now again in a similar ‘influence’ game which further pushes up market favorites, against a very helpful backdrop of near-zero interest rates.

Instead of Merck, the company that is probably a good comp to Facebook today is Google (GOOG). Not a perfect comp, but close enough. So here is a comparison of their evolution.

Facebook’s market cap is now very close to $200 billion. Its projected sales for 2014 are around $12 billion, which means that its stock is trading at over 16x forward sales. To many, this valuation seems justified by Facebook’s very high margins and growth rates.

Google’s market cap reached $200 billion for the first time in 2007. Back then, its revenue growth rate was similar to that of Facebook today (not far from 60%) and its margins were slightly lower. Google stock in that year traded in a range of 8 to 14x sales, significantly lower than Facebook today.

Judging by what happened in subsequent years, you could say that Google’s 2007 peak valuation was justified. Since then, Google’s market cap has doubled to exceed $400 billion today. So if you are a Facebook bull, you can pencil in $400 billion as a target market cap and $150 target stock price.

The main problem with this logic is that things rarely evolve in a linear fashion. In other words, on the road to $400 billion and $150, we may first see $100 billion and $38.

An investor who bought Google stock in late 2007 and who held until today has outperformed the S&P 500 by a wide margin. But all of this outperformance has occurred in the 18 months from July 2012 to December 2013. In 2008, Google stock crashed like everything else, falling by two thirds, and its stock did not regain its 2007 high until late 2012.

Nonetheless, despite the 2008-09 crisis, Google sales continued to grow, albeit at a lower rate. Revenue growth was 56%, 31%, and 9% in 2007, 2008 and 2009. It reaccelerated in the subsequent years 2010-2013, to 24%, 29%, 32% and 19%.

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(Tables show 2014 year to date.)

As shown in the table, these are attractive growth rates but a far cry from what they were in the years to 2007. Even if you ignore the 2008-09 collapse, sales growth at Google has been on a long-term downward trend. It is very difficult if not impossible for a large company to maintain 50% growth rates.

Screen Shot 2015-04-22 at 4.15.25 PM

Going back to Facebook, there are no doubt multiple justifications to hold the stock: the increased role of mobile, the potential for higher revenues per user, the integration of acquisitions etc. But a long position is betting on both flawless execution and a supportive macro environment.

At current valuations, the stock is priced for perfection not only at the micro level (its own operations) but also on the macro level (the overall economy and market). The odds are we will not see a major crisis like 2008 again soon, but what happens to Facebook stock if the economy slows down? Advertising is a notoriously cyclical business. What if Facebook’s own growth rate slows from 60% to a still strong 30%, as happened at Google? From a level of 16x sales, Facebook’s stock would certainly fall by 20%, 40% or more, depending on the severity of the slowdown.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Facebook stock or any other security. The reader is responsible for any loss he may incur in such trading.

Large Stocks Are Widely Mispriced

11 July 2014

Research suggests that when investors influence each other, the stock market becomes less efficient.

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A different perspective

Conventional theory holds that the stock market is efficient and that it does a good job pricing stocks at or close to their fair value, in particular the stocks of large widely followed companies. But could the opposite be true? Could it be that the larger and more followed companies are the less efficiently priced by the market? Could it be that their market value is chronically 20%, 30%, or 40% off from their fair value?

Here is the theory. Assume that there is a finite number of investors, say 1,000 investors, who are active in the stock market and that they each independently derive a value for each stock in the S&P 500. ‘Independently’ here means ‘without sharing thoughts with each other and without letting themselves be influenced by other sources’. Under these admittedly improbable circumstances, the resulting level of the S&P 500 would be quite close to ‘intrinsic value’. We could say that the market would be ‘efficiently’ priced.

Now assume instead that the 1,000 are not working independently but that they influence each other, sharing valuation models, qualitative opinions, price targets, etc. Under these circumstances, the level of the S&P 500 would deviate, in some cases significantly, from its intrinsic value. The market would be inefficiently priced.

This at least is the conclusion you can draw from some recent research on collective decision-making. A recent article titled When Does the Wisdom of the Crowds Turn Into the Madness of the Mob? explains it (my emphasis):

When can we expect a crowd to head us in the right direction, and when can’t we? Recently, researchers have begun to lay out a set of criteria for when to trust the masses.

Democratic decision-making works well when each individual first arrives at his or her conclusion independently. It’s the moment that people start influencing each other beforehand that a crowd can run into trouble.

Philip Ball, writing for BBC Future, describes a 2011 study in which participants were asked to venture educated guesses about a certain quantity, such as the length of the Swiss-Italian border:

“The researchers found that, as the amount of information participants were given about each others guesses increased, the range of their guesses got narrower, and the centre of this range could drift further from the true value. In other words, the groups were tending towards a consensus, to the detriment of accuracy.”

“This finding challenges a common view in management and politics that it is best to seek consensus in group decision making. What you can end up with instead is herding towards a relatively arbitrary position.”

If the research is valid, it debunks the idea that a widely followed stock is efficiently priced. It is not uncommon to hear someone say: “this company is followed by so many people that I have no edge investing in it”. The opposite is almost certainly true: the more widely followed a stock is, and the more ‘influence’ is traded between the participants, the more certain you can be that its market price is wrong, and possibly wrong by a substantial margin.

Take Apple stock for example which is followed by a large number of analysts and investors. When it comes to AAPL price targets, can we say, to paraphrase the article, that the “range of their estimates got narrower, and the center of this range has drifted further from the true value?” And are investors as a group “tending towards a consensus, to the detriment of accuracy?” Investors tend to cluster their price targets not far from the current price which is now $95. But we can theorize that Apple’s intrinsic value is not $100 or $90. It is probably much further from its current market price, say $70 or $120.

Another conclusion can be drawn. When discussing their investment process, fund managers tend to put emphasis on the individual expertise of sector analysts and on their team’s collaborative discussions. In a typical model, the sector analyst will initiate an investment idea and pitch it to a fund manager or to a team who will then reach a decision on how to proceed. In this case, the sector analyst may have been influenced by his peers, by the sell-side and by other sources. And the deciding team members, while searching for a consensus, may have been influenced by each other, by the analyst, and by some willingness to defer to the analyst’s expertise.

If you believe the research described above, this is not the best approach to choosing investments for a portfolio. A better approach would be to have 5 or 10 analysts value the same stock independently, without looking at other sources. It might also be better if these analysts were generalists instead of sector specialists who may be biased in favor of their sector. Once the work is done, there is no point in having any discussions which may prove to be counterproductive. In theory, ‘discussion’ means ‘influence’ and it would result in more bad decisions. It is better to simply look at the valuations derived by these independent analysts. If the average of their price targets is way off the market price, it would be worth initiating a position.