A chapter written by Andy Kessler for John Mauldin's book, Just One Thing.
Years ago, I decided to climb Mount Washington, dragging a reluctant friend, Paul, along with me. It was a beautiful August morning in New Hampshire, not a cloud in the sky, birds chirping—couldn’t be better. Paul ran marathons and had already run eight miles that morning but agreed to my “little hike.” He still had his running clothes on; I was sporting a fresh Blue Oyster Cult T-shirt.
We parked the car and found the trailhead. Next to the usual warnings about poison ivy and rabid squirrels hung a huge sign that read, “STOP. The area ahead has the worst weather in America. Many have died there from exposure, even in the summer. Turn back now if the weather is bad.”
I looked up at the cloudless sky and said sarcastically, “Looks pretty bad to me; let’s roll.”
The climb was strenuous, for me anyway, but not a killer. At some point the trees gave way to rocks, the temperature dropped, and a fog bank came out of nowhere to sit not 10 feet above our heads. We kept climbing until we were engulfed in the fog.
“Any idea where the trail is, Einstein?” Paul asked.
“I can’t see a damn thing.”
“I heard there were trail markers—signposts or something,” I said.
“Like that?” Paul asked, pointing to a barely visible yellow rock sitting on top of a vertical stack of four larger rocks.
We headed through the fog to the yellow rock. When we got there, we were almost able to make out another yellow rock on another stack 10 or 15 feet away. And so we proceeded, making out signposts in the fog, slowly, surely—steady progress, freezing our asses off. At one point we couldn’t make out anything. You could barely see your feet. I wasn’t sure if I was making out yellow rocks or just hallucinating; but we kept heading upward and, sure enough, found another yellow rock, closer to our goal.
It stopped being fun, but it was sure exhilarating. Around two in the afternoon, hungry, cold, and barely speaking, we made it to the top of Mount Washington. Rather than planting a flag, we headed into the restaurant and fought the crowds who took the Cog Railway, drove, or were bussed to the top. Paul and I both bought rather overpriced Mount Washington sweatshirts, wolfed down greasy cheeseburgers, and hung out for about five minutes until Paul said, “Ready to head down the hill?” This time we knew what we were doing.
And that, my friends, is how I learned how to invest.
Investing is hard—as hard as Chinese arithmetic, as another friend Hank used to say. It’s onerous, treacherous, humiliating, and subject to extreme weather conditions.
My old partner Fred Kittler said it best: “The stock market trades to inflict the maximum amount of pain.” I don’t know about you, but I have a very low threshold of pain. Yet I spent a career on Wall Street, first as an analyst following volatile technology companies, as an investment banker, a venture capitalist, and finally running a hedge fund.
I did it by investing in the fog.
You can’t make money standing in the sunshine.
I’d rather be out in the fog where nobody knows nothin’.
As any junior-year “Stocks for Jocks” course will tell you, a stock price is nothing more then the net present value of a company’s future earnings. How easy is that? All you need to know is how much a company is earning today, how fast it is growing, and what discount rate to apply to future earnings to get that net present value. This reminds me of the Saturday Night Live routine with Chevy Chase playing President Gerald Ford in the election debates. Asked about the effect of inflation on budget deficits, Ford/Chase answers, “Uh, I was told there wouldn’t be any math.”
On any given day, the math is quite easy. Widgets ‘R’ Us earned a dollar per share last year. Its growth rate was 12 percent. The inflation deflator is 2.83 percent; hence, the stock is worth exactly $18.42. You can get the formula out of any good economics textbook. Good luck with that.
Maybe the stock really is $18.42. Maybe its $20 and you should short it, or maybe its $15 and you should buy it. I wouldn’t touch it either way. Why?
Because everybody already knows about the $1, 12 percent, 2.83 percent deflator. The sun is shining bright. Say what you want about the efficient market theory, if everybody knows something - you ain’t gonna make money on it. “But the widget business is growing nicely,” you tell me. Yeah, so what? We don’t live in a static world. As my baby’s bib reads, “Spit happens.”
The widget business is not going to stay that way. It’s either going to get better or it’s going to get worse; but unless they are cooking the books, it’s not going to grow exactly 12 percent for the foreseeable future. Yet the stock, today at least, is valued for 12 percent growth.
Inputs to the model change every day. That’s why the stock market is open Monday through Friday. That’s why it is never closed more than one day a week during holidays. Values of companies change. There are a lot of inputs to those silly formulas, almost none of them written in concrete. Sales need to be closed. Profits need to be earned. Spending plans at the beginning of a quarter only guess at how much revenue might support them. Growth is based on global economics. A butterfly batting its wings in Indonesia won’t necessarily change stock values, but a coup in Thailand just might (such events happen every couple of years).
Formulas rarely have an input for risk. Even if they did, it’s an unquantifiable number. A risk-adjusted growth rate is about as specific as economists can come up with.
The problem with Widgets ‘R’ Us, the stock anyway, is that it’s out in the open, right out there in the sunshine. Everybody can see it. Everybody agrees on its prospects. Whoop-dee-doo. The weather’s gonna change.
I’d rather be out in the fog where nobody knows nothin’. Then, if I’m good, I can peer out into the fog and spot some yellow rocks to show the way to a higher level. Once I get to the signpost, it’s quite clear, and my stocks based on getting to that signpost will be properly valued; so I slog on looking for the next signpost.
If I haven’t scared you away from investing yet, you are either persistent or a fool. That’s good; one of these is a good attribute for successful investing.
This whole idea of investing in the fog is NOT about being a contrarian. It’s about seeing things before others. If you think everybody is going to sit in Starbucks sipping lattes using laptops connected to the Internet via Wi-Fi (like I am now), that’s a pretty investable idea. There might be half a dozen interesting investment ideas that would benefit from that trend. But might I suggest that you look around Starbucks, and if everyone is already sitting around sipping and surfing, you are too late. The stock market already knows about it and has discounted the potential growth for chip software and service companies. Sip enough lattes, and you too can hallucinate the future.
Investing in the fog is about seeing things others can’t. Most people get in the fog and panic; but the trick is to get in the fog and feel comfortable, let your imagination run wild, imagine what things might look like up ahead, make out vague outlines in the distance, and invest as if those outlines were real things.
I remember a comedian on Ed Sullivan (I’m dating myself, I know, but it was funny) saying his mother-in-law drank so much, she saw color television years before anyone else. Get her a fund to run!
Over time, if those outlines become real, or even close to being real, you will have invested at such a discount to the eventual value that you will make a killing. Just don’t forget that you are no longer in the fog when you can see what was once an outline and is now living breathing reality. Get ye back into the fog. The stock market always looks ahead. A great investor has a continued paranoia concerning who knows what, what they know, and when they knew it.
The chapter goes on, with sections on Picking the Right Signposts, Finding Intelligence at the Outer Edges, A Glance Back at Satisfaction and Rewards, and an exciting conclusion with Paul and I gorging on lobsters.
Andy Kessler is a former Wall Street analyst and hedge fund manager. His latest book, The End of Medicine, is due out in the summer of 2006.
The book also contains chapters by Rob Arnott, Bill Bonner, Ed Easterling, Mark Finn, Dennis Gartman, George Gilder, Michael Masterson, John Mauldin, James Montier, Richard Russell, and A. Gary Shilling. For more information, click here.