Unfriend Those IPOs

Money Losing Ventures

The downward trajectory of Facebook’s price after its Initial Public Offering (IPO) wasn't a great shock.  Perhaps the bigger surprise is how many column inches have been spent analysing a story that can be summarized as “high price, low earnings, uncertain future”.  Sentiment is a powerful driver of stock prices, but only when there’s money around to back it up.

In fact IPO’s do seem to be generally subject to overpricing, which isn’t as obvious a trend as you might expect, given that owners tend to retain large stakes and to look for ways of retaining control of their precious creations.  For most retail investors, though, IPO’s are probably best avoided on principle.  The principle being not losing money.

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Idiot Noise Traders

Who's Noisy Now?

In 1985 Fischer Black published a paper entitled “Noise”.  In this he argued that much of the irrationality in financial markets could be explained by people trading without information: essentially using various spurious signals to decide when to buy or sell. In fact there’s an argument that without such people markets couldn’t work at all. The downside of this is that it’s difficult to separate the noise from the information.

Black predicted that there would be people who spend their lives trading on noise – so-called “noise traders”; people that Paul Krugman calls "idiots". Unfortunately these idiots generate so much noise that it’s very hard to determine the real information, which would suggest that if we're not careful, at root, we’re all idiots.

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Zombies in the City of London

Attention Deficit Disorder

Often, as I wend my way around the City of London, I find my way blocked by some slow, shuffling, seemingly moronic creature staggering along, head loosely hanging to one side, as it meanders across the sidewalk in a way calculated to force me into the gutter where I’m assailed by tricycling sandwich trolleys, homicidal hackney carriages and a mulch of yesterday’s free newspapers. Yet when I finally get past these drooling monsters it invariably turns out that they’re not zombies at all, merely highly paid financial executives who can’t walk and use their cellphones simultaneously.

In fact they’re suffering from the human inability to multi-task, being unable to attend to two tasks simultaneously – in this case walking and typing. Such minor cases of attention deficit disorder are quite normal but can become a major cause of concern for drivers of automobiles, manufacturers of aeroplanes and all investors – because attention anomalies are at the heart of many flawed investment processes and are, inevitably, used to manipulate investors something rotten.

Don’t Multi-Task in the Driving Seat

The idea that women, or people generally, can multi-task is a myth. Our parallel processing capability is designed for unconscious processing of multiple tasks, not conscious ones. Trying to consciously attend to multiple things simultaneously comes at a price, as we shift our attention backwards and forwards. In essence we have limited cognitive resources and spending these in switching rather than attending reduces our overall performance on all tasks under consideration.

This is increasingly a concern in the cockpits of aeroplanes. Providing too much information to pilots is dangerous, because the more they have to attend to the less likely they are to focus on the really salient issues like the fact that the ground is getting very large very quickly. A similar problem befalls drivers and the increasing range of in-car entertainment and navigation equipment is exacerbating the problem – if a driver stops directly attending to the road for much more than two seconds the risk of an accident increases dramatically.

Incidentally, you might think that if people can’t walk and use their cellphones at the same time then driving and using them might be even less safe. You’d be absolutely right. A mobile phone in the hands of an inattentive driver is one of the most significant dangers facing pedestrians and other road users. For more scary facts like this read Tom Vanderbilt’s excellent Traffic.

More Data, Less Information

In investment the limitations of attention have some different and rather peculiar results. Mainly what seems to happen is that investors, presented with too much data, focus on the wrong bits and make important decisions based on irrelevant information. The problem of figuring out what information to worry about and what to discard gets worse the more we’re presented with. This is a situation where more is definitely less.

In general, though, this poses a puzzle. Markets should get more efficient with more information, not less. One possible answer to this is that the real information is hidden in the excess data, so that as more information is presented it becomes harder and harder to see the wood for the trees. In essence, although information may be available in the public domain the harder it is to extract from the underlying data the less likely it is that it will be.

Potentially this is a rational solution to the failures of efficient market theories. If it’s too expensive to extract the data, because the rewards are ultimately less than the cost, then some information will remain undiscovered by the markets. The inverse is also true, however – if information is easy to extract from the data then it will be and markets will react to it. Which leads us to an interesting observation – that if one or more parties involved in the preparation of the data has a vested interest in keeping some information hidden then they’re likely to do so, as long as regulations permit this.

The Incomplete Revelations Hypothesis

One simple example of this are the headlines which accompany most results statements. Most experienced investors know to look for the dog that didn’t bark – things missing, like a profit statement or a dividend rise. This, of course, is a trivial example but it makes the point: managers of companies may choose to massage their public statements in a legally permissible way to obscure the really important information beneath a mountain of irrelevant data.

Robert Bloomfield points to a range of ways in which managers seek to make information extraction more difficult for investors, all of them strangely biased towards supporting higher stock prices. In his words:

• Managers choose and lobby for accounting methods that improve highly visible data, such as earnings-per-share and debt-equity ratios, and conceal expenses and liabilities in less-visible footnote disclosures.
• Managers classify arguably ongoing expenses as non-recurring or extraordinary items, while reporting arguably unusual gains as part of operating income.
• Managers develop “cookie jar” reserves to maintain the capacity for positive accruals to boost earnings in the future (Nelson, Elliott and Tarpley, 2002).
• Managers announce “pro forma” earnings numbers that emphasize improvements relative to their own strategically-chosen benchmarks, while making it more difficult for investors to observe other measures of performance (Schrand and Walther 2000, Krische 2001)

Underlying Bloomfield’s observations is his “Incomplete Revelations Hypothesis” which provides a way of addressing the problem we discussed in the Special Theory of Behavioural Finance; namely how do you marry the Efficient Markets Hypothesis – which describes how investors should behave – with Behavioural Finance – which describes what they actually do. So an investor may rationally choose not to spend their time extracting difficult to analyse information from otherwise obscure data while simultaneously being viewed behaviourally as showing limited attentional capacity.

Presentation, Not Content

The idea that our limited capability for attention is being manipulated by market participants who’d like us to behave one way rather than another, and that this manipulation can be carried out through the use of public information, shouldn’t come as a big surprise to anyone versed in the ways of the markets. However, what’s more interesting is to view this through the lens of metaphor: results statements are the gadget festooned displays of modern vehicles and while we’re busily attending to the obvious we’re being misdirected away from the important. My word, Mr. Pilot, the ground looks really big outside.

More evidence for this was provided by Maines and McDaniel who showed that the format of income statements affected the evaluation of the information by investors. This research was directed only at non-professionals so perhaps you might not find this too surprising. However, as usual with behavioral finance, what applies to amateurs also applies to professionals so when Hirst and Hopkins did the same sort of research on the latter group they found that financial analysts also had difficulty in identifying artificially inflated earnings statements. As they put it:

“…we believe this result is not surprising given the variety of possible ways a company can manage its earnings, the non-trivial effort required in detecting any of these activities, and the difficulty in distinguishing earnings management from other events”.

Quite.

Leave Our Zombies Alone

This type of underlying cognitive limitation comes with the territory of being human and gives the lie to more is better when it comes to data. The truly great investors develop their own analysis methods to cut through the chaff rather than relying on discovery by others, while the oft-quoted advice that people should only invest in what they understand also arises out of this limitation.

From all of this we can gain a few useful rules. Firstly, if you must invest in individual companies do your own research, read the footnotes and make sure you know what they mean. Secondly, avoid using any gadget in a car that requires dividing attention between it and the road. Finally, leave our zombies alone, because interacting with them may cause a significant overload in their liquefying brains. The world of high-finance has enough trouble already without losing its brightest and best under the wheels of a sandwich trolley tricycle.


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