Ivanhoff Capital

George Soros is known as the “man who broke the Bank of England” in the early 1990s, but his main contribution to the financial world is the theory of reflexivity, which claims the following:

• Prices aren’t objective; they’re based on people’s biased perceptions of the future;
• Biased perceptions define people’s buys and sells, so perceptions will influence prices;
• Prices impact perceptions and fundamentals too; therefore perceptions could impact fundamentals.

Soros’s reflexivity theory is also a common-sense explanation of why trends exist and why price momentum could be an excellent equity selection filter.

What happens when the price of a stock makes a new all-time high?

1)   The market is considered a feedback mechanism. When prices go up, people assume that their initial investment thesis is right and their expectations justified. They buy more and are joined by even more people wanting to participate in the trend. The fear of missing out is ruling market’s behavior.

2)   Higher stock prices mean happy shareholders. Since the manager of our company has made his investors a lot of money, he receives a lot of good faith and patience for future experiments. This manager could make a lot bolder moves and he is given more time to be right.

We have all seen the incredible faith that Amazon’s shareholders have in Jeff Bezos. 16 years after its IPO, Amazon still losses money on the occasional quarter, because it invests heavily in new projects. Amazon missed Wall Street’s earnings expectations in four of its last five reports. Any other stock would have been killed for missing estimates so many times. Not Amazon. Its stock climbed 50% in the past year and a half.

Management is an important part of the fundamentals of one company. When investors trust and believe management, they are willing to give his/her company a lot higher P/E multiple, and for a good reason. Investors tend to trust managers that make them money.

3)   The company could use its appreciated stock as a currency in order to acquire smaller competitors and the best human talent in its respective field, which makes it a lot stronger, functionally and operationally. We see how Google is scooping up many of the best engineers in the world. We see how Salesforce is incredibly active on the acquisition field. Better people, new and better products, less competitors are all factors that actually improve company’s fundamentals and they could be all derived from higher stock prices. The improved fundamentals attract a completely new set of buyers, which props the prices even higher.

And all of this could be started with just a good story about a better future. This is how perceptions become a reality.

Prices change when expectations change and expectations change when prices change. A good story that could capture the imagination could change expectations. The dream of future profits is what excites people, not the reality.

This is how momentum works, but the process does not last forever. People’s expectations about the future don’t always come true. The market constantly tries to discount events that have not happened yet. As a result, it will sometimes discount events that will never happen. The market is forward looking, but in the same time it is constantly looking for a feedback: in short-term perspective from price; in longer-term perspective – from fundamentals.

Sometimes, expectations turn into a self-fulfilling prophecy and end up impacting fundamentals. More often than not, the discounted future is way too optimistic or pessimistic. It is human nature to over-discounts identified risks and opportunities.  When the market realizes that it is not right, it just gaps in the other direction and starts the process of correcting its mistake – that process is usually a lot more violent and quicker.

When I try to explain the stock market to people with no experience, I always start by telling them that buying a stock is just like buying part of a business. It gives you the opportunity to invest in other people’s ideas, participate in the growth of promising businesses and take advantage of consumer and economic trends. I admit, it is a very rudimentary explanation of how the stock market works, but I don’t want to scare people from the get-go.

This is the way Warren Buffett thinks and invests. You have probably heard of his favorite stock market story about one of his long-term holdings – Coca Cola. Coke became a public company in 1919 at the price of $40 per share. A year later, it was trading at $19 and the IPO buyers were down more than 50%. You can always find a few reasons why it was not a good time to buy it, but if your grandmother bought one share at $40 and re-invested the dividends, she would have had $5 million today. “There is never a perfect time to buy a great business”, Buffett says – “There are always reasons to worry, but if you are right about the business, you will make a lot of money over time”.

It almost sounds too simple, right? Buying a stock is buying a part of a business. The truth is that more often than not, there is a huge disconnect between a company and its stock. Sometimes you will spot a big consumer trend and a business you would love to own, but that does not mean that you have found a sure money maker. The odds are that other people have made the same observation and the stock market might have already discounted the trend.

You are never just buying a piece of a business. Take for example, the retail giant Walmart. If in the early 2000s, you thought that it will expand substantially over the next decade, you would have been absolutely right. Walmart more than doubled its earnings and revenues in the past twelve years. Do you know how much money its investors made? Almost Zero. Its stock practically went side-ways for 12 years. Earnings growth is not the only factor that impacts stock prices. Just as important is the P/E ratio that the market is willing to pay for it.

The outcome of your investment depends on the price you pay for it and on the price other people will be willing to pay for it in the future. There are no guarantees that if one company keeps growing its sales and earnings, its price will continue to appreciate. The market is forward looking and constantly discounts 6 to 12 months into future. When you buy a stock, you are not just buying a piece of business, you are buying the current expectations about the future of this business – sometimes, it pays to buy extremely low expectations – value investors’ approach. Other times it is worth paying for quickly rising expectations – momentum investors’ approach.

Investing is not only about owning part of a business, but also understanding how different catalysts will change people’s perceptions over time.