Value Investing: How To Invest Like A God
Value Investing: How To Invest Like A God
Could a God who can see the future beat EMH? Yes, it's called Value Investing.
"The beauty of such an investing principle lies in the versatility of its application. It can take the form of Graham’s cigar butts, Buffett’s compounders, Peter Lynch’s diversified growth, Howard Marks’s counter-cyclicality, Michael Burry’s deep value, Monish Pabrai’s asymmetric risk:reward or Li Lu’s high conviction. None of them exclusively represent Value Investing; yet all of them observe its fundamental first principles."
TABLE OF CONTENTS:
1. Could A God Beat EMH?
2. Exorcising Black Swans
3. It’s Market Outcomes That Matter (Not Real-Life Outcomes)
4. How To Be A God (In Markets) i.e. a Value Investor.
i. Low-probability events matter in investment decision-making
ii. It is not real-life outcomes that matter, but market outcomes.
c. Investing Like Gods: Combining i. and ii.
5. Low-Probability, High Impact Investing
Q: Could you invest like an all-seeing god who can see the future?
To answer this question, let us first clarify the definition of the Efficient Market Hypothesis (EMH). For the purposes of this article, we will only be discussing strong-form EMH1.
Many value investors seem to think that strong-form EMH means that markets are always correct about the future, by virtue of having millions of eyes on the same asset, and therefore pricing it efficiently. However, the actual definition of strong-form EMH according to Investopedia doesn’t actually imply that:
The strong form version states that all information, public and not public, is completely accounted for in current stock prices, and no type of information can give an investor an advantage on the market.
The existence of EMH doesn’t imply that markets are correct about the future all the time — it merely says that there’s no point in stockpicking, since market prices have already accounted for all known information across society, thus arbitraging away any further upside based on fundamental values.
The logical corollary here is that that such “all known information” has to be at least “known” by some humans in the world in order to be priced-in. But what about “unknown” information that nobody except a god would know — such as information which lies in the future?
Shout-out to Tech Investment’s excellent article about HBM and SK Hynix below!
Could A God Beat EMH?
Let’s assume that one of the Greek gods came down from Mt. Olympus, and decided to try their hand at modern-day stock markets. Unlike us mere mortals, these gods have the uncanny ability to be able to see into the future.
Would EMH thus apply to Them? The answer is no, because a true God would be privy to even “unknown” information — i.e. information which only exists in the future, and which doesn’t yet exist in the present-day. Thus, they could prophesy which stock would outperform in the future, and simply buy it today in truly risk-free fashion.
What might such “unknown” information look like? Think of some of the global developments which have occurred recently that could be categorized as “unknown” future information. The pandemic, Ukraine war, Israeli-Gaza war, the rapid improvement of the US economy — all of these would be widely considered as “unknowable” in advance, no matter how good the investor.
Statisticians would call these “black swan events”. In essence, these events have such low probabilities of occurrence (e.g. single digits) that no rational human actor would consider pricing them into market prices. It would simply be too “inefficient” to do so.
The problem with such a position is that black swan events actually occur with regularity in macroeconomics — the past three years should bear testament to that. And as past share prices have demonstrated, all (human) market participants in aggregate miss these low-probability events all the time. This is why Howard Marks said in a recent interview that “an economist is a portfolio manager who never marks to market”:
However, clearly a true god who can perceive the future would not have such a problem. By virtue of having an all-seeing eye, He would be able to identify exactly which low-probability event in the future would happen, and pick a stock which hasn’t priced-in such future “unknown” events yet.
The reason why I’ve incorporated literal gods into this illustration is to really drive home the weakness of even strong-form EMH in correctly predicting future market outcomes — only an actual god could do that consistently. No human could, not even a JP Morgan analyst.
In truth, our statistical framework of market valuations is quite flawed in representing the truth about the distribution of future probabilities. And yet in benchmarking an investor’s performance to future investment outcomes, our financial status quo sets market expectations at the level of an all-seeing god.
Exorcising Black Swans
Think about the weight of what I’ve just described. Just because a market event has a low-probability of occurrence, that doesn’t mean it cannot happen — which is how we tend to treat black swan events. In reality, these kind of low-probability events happen ALL THE TIME, with devastating market impacts.
But why do low probability events happen all the time in markets? It’s simple — the world is inconceivably vast. When you have a gazillion different Category 5 risks simmering under the surface at any given time, just one of them materializing could trigger a cascade of other risks like dominoes, often culminating into a newsworthy global tragedy.
This is where the dissonance between statistical expectations and actual portfolio outcomes hides. If your portfolio is ant-sized, even a slight nudge of your anthill would be enough to collapse it. And just because a particular risk has a low probability of occurrence is irrelevant. In the grand scheme of things, the sheer vastness of the world virtually guarantees that at least one such event has a reasonable chance of happening in your backyard at any given time. Couple that with the contagion effect of different risks, and you can see how reasonable this assessment is.
Lesson No. 1: Low-probability events matter in investment decision-making. Ignore them at your peril.
Obviously, a god wouldn’t have a problem with this, since they’d just peer into the future and plan around it. So how can value investors incorporate such divine prophesy in their portfolio decisions?
It’s Market Outcomes That Matter (Not Real-Life Outcomes)
If the world is truly so vast as to render even low-probability events potentially earthshaking to our ant-sized portfolios, then obviously we cannot ignore low-probability risks in our investment decisions. But what can we do then? Surely it’d be unrealistic to account for every single risk in the world?
The good news for (human) investors of public stock markets is that we aren’t actually beholden to future real-life outcomes. We are actually beholden to are future market outcomes.
This is an important distinction to make, because market prices tend to be efficient — i.e. prices and fundamental values tend to equilibrate. For instance, high-probability risks tend to result in low share prices; whereas low-probability risks tend to result in high share prices.
Hence, it is not the development of actual risks in real-life that matters, but the impact of risk on the trajectory of market prices. In other words, if the development of a risk in real-life results in no impact to market prices, that’s totally fine!
Let’s illustrate this with an example. Suppose a bank business isn’t doing so well today due to an egregiously inverted yield curve. Markets would therefore price-in the future risk of real-life underperformance, resulting in a lower valuation. Hence, even if that risk materializes in the future, its valuation shouldn’t fall further — because it’s already priced-in.
Now let’s imagine that the risk doesn’t actually materialize. Since that anticipated risk has already been priced-in, its evaporation in real-life should result in the bank’s valuations reversing back up.
This example shows how it is not actual real-life outcomes which matter, but their impact on stock prices which do. And that depends very much on whether those outcomes will impact share prices, rather than the occurrence of those outcomes per se.
And it is here that we can begin to wield the power of the gods — by exploiting not just market probabilities, but market impacts.
Lesson No. 2: It is not real-life outcomes that matter, but market outcomes.
How To Be A God (In Markets), i.e. a Value Investor.
As we’ve explored above, strong-form EMH only prices-in what humans can foresee. It doesn’t price-in what only gods can foresee, but humans can’t.
Hence, to beat the market the solution is simple: invest in outcomes that only gods can predict. Simple, right? But as mere humans who can’t predict the future, how can we put this into mortal practice?
The good news is that we don’t need to invest in real-life outcomes that only gods can predict. Rather, we can invest in market outcomes that only gods can predict!
To illustrate this, we need to combine the two lessons we’ve learned above:
Low-probability events matter in investment decision-making.
It is not real-life outcomes that matter, but market outcomes.
Lesson No. 1: Low-probability events matter in investment decision-making
Imagine if you had invested in a low-probability outcome and it turns out wildly in your favor — whereas everyone else had missed out on it. You’d look like an investing god right?
One such example of this might be when I invested in META right at the bottom in Nov 2022 — it’s up nearly 450% now. Did I predict that this would happen? Certainly not, in fact I was quite upfront about not knowing what would happen in that META article.
However what I did know even then was that META’s valuation was roughly 8x trailing PE at the time. To me, it sounded completely absurd that even the emergence of a rival Tiktok feed would render its database of 2 billion people in the global middle-class population irrelevant. At worst, it could simply diversify into the advertising business — more than justifying an 8x trailing PE.
Obviously, markets considered such a contrarian take a low-probability event, as evidenced by its share price at the time. And yet, it most certainly ended up mattering. This naturally segues into…
Lesson No. 2: It is not real-life outcomes that matter, but market outcomes.
Notice how I described my thought process behind META in Nov 2022. I described it as trading at 8x trailing PE, more than enough to justify the worst-case scenario.
That means that what I cared about wasn’t META’s real-life outcomes, but rather its market outcomes! While markets were worried sick about Facebook potentially being disrupted by Tiktok, I was thinking about how markets had already priced-in such a risk, and therefore the downside was practically nil.
Even if Facebook’s business did get disrupted by Tiktok as expected, META’s share price was unlikely to fall by too much more — even if it did something radical like diversifying into the advertising business! This is exactly how I framed my bank stock example above.
And similarly to my bank stock example above, the subsequent rapid evaporation of the Tiktok risk (which nobody could have predicted, including myself) resulted in META’s market valuations correcting back up — as the anticipated risk that was priced-in failed to materialize.
This is what George Soros meant by his following quote:
'It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.'
As we can see, Soros was not preoccupied with the likelihood of occurrence of real-life outcomes (“right or wrong”). Rather, he was preoccupied with their market outcomes (“how much money you make/lose” when they occur).
Investing Like Gods: Combining Lessons No. 1 and 2
So how do value investors exploit the overlap between these two lessons? Allow me to use my META example above to illustrate further.
Firstly, META was only valued at 8x trailing PE at the time because markets had considered a rebound in its fundamentals a low-probability event. In other words, investors are unlikely to find bargains in high-probability events widely agreed on by market consensus, since EMH equilibrates share prices and fundamental values.
At the same time, META’s low valuation at the time (contributed by low upside probabilities) also meant that further downside risk was low, since markets had already fully priced-in such risks.
Conversely, markets had failed to price-in any possible upside to META — resulting in anyone who had bought their stock at the time looking like an investing god today.
Do you see how value investors “Invest Like Gods” now? By turning our attention away from:
the normal probability distribution of real-life outcomes built into consensus valuations, towards
the “abnormal” distribution of market outcomes, which can deviate from the normal probabilities of real-life outcomes (built into consensus valuations)
…we can exploit market inefficiencies by taking contrarian positions (i.e. low upside probabilities) — which, should such low probabilities actually materialize, would make you look like an investing god!
The only mandatory caveat here that must be observed is that care must also be taken to ensure that even if such low probability events fail to materialize, one does not incur any risk.
Luckily, underperforming stocks whose battered valuations have already priced-in future risk typically naturally sport significantly reduced risk — by virtue of their battered valuations alone.
By doing so, we truly put into practice Soros’s quote above:
'It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.'
Low-Probability, High Impact Investing
In fact, this is not a particularly novel application of low-probability, high impact strategies which only belongs to value investing. Classical finance also advocates for such an investment approach — you may have heard of it before: Asymmetric Risk:Reward.
At its very essence, this is what Value Investing means. It is to invest with a Margin of Safety, where you Never Lose Money no matter what happens, with a portfolio designed to promise safety of principal and adequate returns.
The beauty of such an investing principle lies in the versatility of its application. It can take the form of Graham’s cigar butts, Buffett’s compounders, Peter Lynch’s diversified growth, Howard Marks’s counter-cyclicality, Michael Burry’s deep value, Monish Pabrai’s asymmetric risk:reward or Li Lu’s high conviction. None of them exclusively represent Value Investing; yet all of them observe its fundamental first principles.
If you’d like to know more, the articles below will get you up to speed on these value investing principles:
The only difference between value investors and actual gods is that the latter is able to see the future; while the human value investor is merely exploiting the inherent inefficiencies in statistical attribution of market prices to future real-life outcomes2 — and positions his portfolio for low-probability but high impact outcomes3.
In fact, many of the legendary value investors are actually quite upfront about their inability to forecast future market outcomes — these include self-made billionaires like Warren Buffett, Charlie Munger, Benjamin Graham, Howard Marks and Seth Klarman. Ironically, in teaching us to try and accurately forecast market outcomes, it is classical finance theory that assumes that we are gods who can actually see the future.
I’d invite you to read some of my previous stock reports on this newsletter to determine for yourself whether I’ve actually been faithful to the value investing methodology as I’ve described above. This is what Value Investing really means!
Check out our previous stock reports:
Disclaimers:
Disclaimer: This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the authors. To the best of the authors’ abilities and beliefs, all information contained herein is accurate and reliable. The authors may hold or be short any shares or derivative positions in any company discussed in this document at any time, and may benefit from any change in the valuation of any other companies, securities, or commodities discussed in this document. The content of this document is not intended to constitute individual investment advice, and are merely the personal views of the author which may be subject to change without notice. This is not a recommendation to buy or sell stocks, and readers are advised to consult with their financial advisor before taking any action pertaining to the contents of this document. The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties and other factors, most of which are beyond the authors’ control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.not the weak and semi-strong forms of EMH, as they are already accounted for by strong-form EMH.
which assumes a normal probability distribution of outcomes, but does not do the same for the impact of outcomes.
obviously such high-impact outcomes would preferably have an upside bias, rather than a downside bias.