Value Shorting

I recently read Has the Meteoric Rise of Passive Investing Generated the Greatest Bubble Ever from 13D Research.

The article references a good point from Noah Smith and Bloomberg¹: “No one knows the basic laws that govern asset markets, so there’s a tendency to use new technologies until they fail, then start over”. I think its clear that ETF’s and passive investing fall into this category. The space is completely new. We don’t know how an algorithm will react to a major disturbance, and I don’t want to find out. Eventually, we will and that should scare you.

When you give money to another human to invest on your behalf, its a lot easier to recognize inherent bias in their investing strategy or personal beliefs. Anyone can figure out if their money manager’s inherent investing bias is good or bad by simply looking at past performance. As the article notes, this performance judgement is typically made in relation to the S&P 500 (did x money manager beat the S&P last year?). A problem with trying to make the same comparison for a passive money manager is that they are investing directly in this “benchmark”. From the article: “If the passive investors behave dysfunctionally, by definition this cannot be reflected in underperformance, since the indices are the benchmark.” What’s going to happen when the benchmark (S&P 500) stops increasing? Who’s fault is that?

A particularly scary example was about Exxon. Go to the article and read the paragraph if you’re interested. What I think is most important to recognize from the example, and perhaps the entire article is the apparent abandoning of fundamental analysis of a company before buying shares of the company. The herd affect and marginalization of price discovery appear to be significantly overpricing companies in all sectors. Algorithms invest based on what they have (machine)-learned from past performance of a stock. When a computer makes a decision to buy shares of stock, its doing this because the price may have just dipped or because it recognized a historical cycle and is hoping the stock will repeat its past movement (I could be making too much of an over-simplification but I think that captures the general idea). As far as I can tell, the algorithms that handle passive investing for millions of investors don’t worry about a company’s earnings, revenues, cash flow, etc. when they are buying or selling stock. Its scary to think about what might happen in the event of a correction, but I think this is an important opportunity.

From Investopedia²: Value investing is an investment strategy where stocks are selected that trade for less than their intrinsic values. Value investors actively seek stocks they believe the market has undervalued. I think the same thinking can be applied in the present market, but for securities that the market has significantly overvalued. As has been popularized by legendary investors (Dodd, Graham, Buffet, Klarman, others), the margin of safety is a guideline to help decide when it is a good time to buy a stock. An investor should only purchase a stock when it is priced at a margin of safety below its intrinsic value. The thinking is that this margin filters out possible mistakes and oversights in the fundamental analysis of a stock’s value, thus reducing risk that you buy a stock and it doesn’t raise in price. Furthermore, because you are buying a stock at this significant discount, it should increase in price to its intrinsic value, which is where you sell and take your profit. Right now its hard to find a stock that is underpriced, but it should be easy to find a stock that is overpriced. Adding on to that, the current geo-political landscape seems to be teetering on the brink of catastrophe, which has great potential to cause a major price adjustment, especially given what has been said above about ETFs and passive investing. Fundamental analysis to find overpriced stocks, and then shorting the stocks that are overpriced by a margin of safety above their intrinsic value has potential to make someone a lot of money. This is not investment advice, but food for thought as we see the growth of passive investing and money flooding into stocks without much thought being given to the companies represented in the markets.