Quality Signalling for Quality Stocks

Exeunt Investor

Making money from trading stocks should be ridiculously easy; after all,all you have to do is buy low and sell high. Which makes it a recurring mystery as to why so many people so often do the opposite. After all if you buy something at £5 and it drops to £4 it’s cheaper, right?

It’s not just with stocks that this problem occurs, although it’s just not so obvious elsewhere because we tend to buy goods and keep them rather than re-selling. Generally when we’re buying something we don’t understand too well we tend to look for signals that tell us whether it’s of a decent quality or not. Often one of the main signals we use is the price, such that a higher price is believed to identify goods of higher quality. Ergo, if the price goes down then that’s signalling something too: in the case of stocks, that we’ve made a mistake. Exit investor, followed by losses.

Geejaw Magic

Signalling theory is a powerful side-channel in economics – it’s been used to explain many phenomena otherwise inexplicable to financial experts. The power of advertising, as we saw In Advertising on the Handicap Principle, is ascribed almost entirely to the powerful signals of quality and stability that it emits through an otherwise pointless display of ostentation, wealth and power.

Robert Cialdini, in his wonderful book Persuasion, tells the story of a friend who tried everything she could think of to sell some jewellery. Finally she:

“Scribbled an exasperated note to her head saleswoman, “Everything in this display case, price x ½” hoping to be rid of the offending pieces, even if at a loss. When she returned a few days later she was not surprised to find that every article has been sold. She was shocked, though, to discover that because the employee had read the “½” in her scrawled message as a “2”, the entire allotment at sold out at twice the original price!”

The purchasers, tourists mainly and knowing nothing of the intrinsic value of what they were buying, were acting solely on the signal emitted by the price. Higher is better, no?

Scary Stock Signals

There are, sadly, people around who apply exactly this premise to stocks, believing that one trading at $100 a share is more valuable than one trading at $50, but there are always some people you can’t help. Mostly, though, people buy stocks for other reasons – stuff like Ben Graham's fundamental analysis of intrinsic value, Philip Fisher's scuttlebutt assessment of future growth or John Maynard Keynes’ beauty contest assessments. Or sometimes, they buy simply because they know the stock.

Whatever the reason the absolute share price of the security is unlikely to be a reason for a purchase – but relative changes in the price of a tracked stock can trigger investors into buying: sadly just because a stock has fallen 50% doesn’t mean it can’t fall another 100%. In any case, once bought, the investor is exposed to the full force of signalling theory. This starts, usually, by anchoring on the purchase price which is then used as a reference to evaluate any future price movements.

Pollen Pointers

That rare band of deep value investors who only buy stocks at a discount to intrinsic value and who only buy stocks they understand are just about the only people immune to the signals of a falling share price. People find it almost impossible to accept that prices can move up, down or do the Hokie-Cokie for no particular reason other than boredom, so they come up with a weird and wonderful array of reasons for such movements. It’s like early microscopists watching pollen grains moving around and concluding they were alive, rather than being battered by unseen molecules randomly charging around performing their version of the random walk.

So just as the price of jewellery signals quality so the relative change of price of a stock indicates merit to the owner. Only, of course, in both cases this very often isn’t true. Just like pollen grains stock prices can move around for all sorts of reasons, not the least of which is the lots of investors who don’t know very much have bought up all the available shares and then start to play a game of hunt the Greater Fool as they trade amongst themselves. A price rise – or a fall – may signal further short-term rises or falls but tells us nothing about the future prospect of the corporation.

Asymmetric Information

The problem that investors face, and which they’re trying to solve through reading, or misreading, signals is that of asymmetric information. Basically they’re worried that someone else knows more than they do and read purpose into what may well be purposeless and random oscillations. Only they might not be, which is what worries investors.

Typically the literature on asymmetric information distinguishes between two different types of situation – those involving adverse selection and those involving moral hazard. Adverse selection typically applies when the seller is providing goods of standard quality and needs to provide the purchaser with a way of distinguishing between themselves and other providers of similar but inferior goods. Moral hazard occurs when the seller can change the quality of what they’re providing between one transaction and the other.

Signalling Quality

Signalling can resolve situations of adverse selection as Amna Kirmani and Akshay Rao explain in No Pain, No Gain: A Critical Review of the Literature on Signally Unobservable Product Quality:

“Signalling is a viable strategy when two conditions hold: (1) For the high quality firm the gains from signalling outweigh the gains from any other strategy … (2) For the low quality firm, a non-signalling strategy provides a bigger payoff than does signalling”.

Basically for signalling to work for the higher quality firm the costs to the lower quality firm of copying them must outweigh the benefits. Of course, a company that consistently offers a high value product and is able to successfully signal that fact to the market is the ideal investment: it’s a moated, quality business, likely to provide above average returns over an investing lifetime.

The Business of Moral Hazard

Companies that engage in moral hazard, on the other hand, are investments that we typically want to avoid, since no signalling strategy is likely to be very good at stopping them misbehaving. The financial institutions so heavily implicated in market collapses over the decades are a perfect example of such corporations – you never know exactly what you’re going to get from one transaction to another. As Kevin Dowd puts it, in Moral Hazard and the Financial Crisis:

"A moral hazard is where one party is responsible for the interests of another, but has an incentive to put his or her own interests first: the standard example is a worker with an incentive to shirk on a job. Financial examples include ... I might sell you a financial product (eg., a mortgage) knowing that it is not in your interests to buy it".

Such businesses simply don’t yield to detailed analysis since we’re trying to hit a moving target. If you absolutely have to invest in these companies then doing it on the basis of the quality of the management rather than the quality of the business is likely to be about as good as it gets. And when the management changes: beware.

Where the Quality Lies

There are all sorts of ways for a company to emit signals – advertising spend and branding being the most popular. These lie behind the intangible assets of companies and are as real as bricks and mortar, albeit rather harder to value. Warranty length is another one, where durable products are concerned: only firms producing high quality goods can afford lengthy warranties.

The obvious problem with signalling models is that they assume that the purchasers are more or less rational, which is a dubious restriction. Despite this there’s little doubt that signalling does occur and we do react to it, with predictably dubious consequences. In situations of uncertainty we grope around for any sort of signal that tells us what to do, whether it’s following overconfident leaders into unwinnable wars or buying overpriced jewellery as a souvenir. In stockmarkets which, by definition, are situations of uncertainty we want to use this in our favour – for long term investment security we want to find those stocks that don’t deal in moral hazard and can overcome adverse selection through signalling: that’s where the quality investments lie.


Related articles: Akerlof's Lemons: Risk Asymmetry Dangers for Investors, The Psychology of Dividends, Technical Analysis, Killed By Popularity