the research puzzle
May 27, 2010
I found myself at a luxury car dealership the other day, talking to a salesman about pricing. I was trying to get at the price/value structure versus the competition. He was very open about everything and said, “People are willing to pay up for the name, and for this.”
The “this” was accompanied by a gesture that indicated the modern suburban luxury dealership. Expansive and polished to the nth degree, with a large room full of comfy leather chairs for those waiting during the servicing of their cars, an equally large room with work tables for those not at leisure, and a “library” behind. Huge televisions, lots of goodies, you get the idea. Although it looked out of favor for awhile during the last couple of years, apparently glamour still sells.
As investors, we must constantly monitor how much we are paying for glamour versus intrinsic value. You’ll often hear debates about the relative merits of growth investing versus value investing; I prefer the lingo typically found in academic studies, where the terms “glamour” and “value” are used instead. The performance evaluations inevitably favor the latter strategy, because much of the glamour is really faux growth that is misidentified for a time.
The largest audience I ever saw at an IPO road show was for Trilogy Systems. It had a story (wafer-scale integration), but what was really for sale was the glow of success around founder Gene Amdahl. A few months later, I visited a number of companies with a group of analysts. By then Trilogy stock was trading at a dollar, and the buyers of the deal must have struggled to control their anger as they walked into the headquarters of that start-up firm and saw the rosewood-paneled walls and brass railings. As we sat in a large meeting room, a screen descended from the ceiling and the man next to me muttered, “I paid for that screen.”
Of course, the anecdotes could go on forever (reviewing just some of the dot-com ones would be exhausting). The general problem with glamour investments is that the odds seem to be working against you. Sure, there are real growth stories out there, and if you are good at finding them you can pay glamour prices and still have attractive returns. It’s just that for long periods of time there aren’t too many nuggets of gold in the stream.
Since paying up for glamour is one of the most common investment mistakes, your investment process should be structured to force you to wrestle over and over again with the changing dynamics of valuation and fundamentals.
As an example, we can start with those macro situations that have earned the “bubble” moniker, like the aforementioned dot-com bubble, the housing bubble, etc. Most can be analytically parsed as they develop by reducing them to simple economics. A look at the facts indicates that higher prices are needed to sustain the momentum, that the underlying numbers have gone past making sense; it has become a momentum game. As always, knowing which game you are playing is critical. At the top of every bubble, people are caught playing a momentum game while convincing themselves that the fundamentals support prices without really checking to see if they do.
Headline-grabbing events aside, as prices vary for individual stocks and sectors, the rubber band of valuation is stretched here and there as the price of glamour (or of its anti-matter, characterized by disgust and revulsion) fluctuates. True underlying value changes much more slowly. That sets up a key question to answer: “Given my strategy, what do I do about it?”
For those who believe in pure momentum, their money management rules, placement of stops, and strategies for momentum breaks had better reflect the fact that prices get out of whack and that the goal is to capture the upside moves and not the downside ones. On the other side of the spectrum are those unique investors who can anticipate glamour and see what the crowd is going to fashion before it actually does. It’s obvious that the errors in that strategy are completely different.
No matter your approach, the evolution of glamour pricing likely matters, perhaps more than you think. You should be able to articulate how your strategy intends to deal with its fickle nature, and you must ensure that you have the execution methodology to back it up.
Otherwise you could find yourself one day sitting in a Hummer that used to be cool and now is just a delivery vehicle for bad economics.
 Daniel Beunza wrote on this recently in terms of an “ultimate bottleneck strategy.” http://socfinance.wordpress.com/2010/05/25/how-to-bet-against-a-bubble-the-ultimate-bottleneck-strategy/
Tom Brakke, CFA, is a registered investment advisor, in addition to providing consulting services to investment organizations and advisors about how to structure processes for better decision making. This piece was originally published on his blog, the research puzzle.
(c) the research puzzle