The Dumb Smart Market

In yesterday’s piece on the recent fortunes of Dell Computer (which only worsened today), I suggested that even though some of the market’s most popular stocks–Dell, Microsoft, Coke, Cisco–seemed to be outrageously expensive, in fact if you looked at the comparative return on invested capital (ROIC) of these companies you found that their uniquely high valuations were deserved. Then, more dubiously, I argued that it’s no coincidence that the best companies in terms of ROIC were also the most highly valued, even though most investors have never even heard of return on invested capital. The market is recognizing value, even though it couldn’t say why.

How is this possible? In the simplest terms, you might say that markets are collectively intelligent even when the actors who make up those markets are individually dumb. Consider these two examples, which I’ve taken from Michael Mauboussin, an investment strategist at Credit Suisse First Boston and probably the most interesting thinker on Wall Street today. Mauboussin teaches a class every year at Columbia Business School, and every year, before one of his classes, he hands his students a form and asks them to estimate IBM’s assets at the end of 1989 (not a number that you would expect even business students to know exactly). Every year, without fail, the mean of all the responses is within 5 percent of the actual number.

Here’s an even stranger one: every year, Mauboussin assembles a good-sized group of people (100-125 people) and gives them a ballot for the Oscars. On one side are the six most popular categories–Best Picture, Best Actress, Best Actor, Best Supporting Actor, Best Supporting Actress, Best Director–and on the other are six more estoeric categories. To play, each participant chips in a dollar and then guesses who will win the Oscar in each category. Obviously, some of the participants know a lot about the movies and about the Oscars, and some know very little. But without fail, the group’s mean response across the 12 categories does better than any single human. Two years ago, the group got 11 out of 12 right, while the best human only got nine right.

I don’t know about you, but I find these stories absolutely eerie and absolutely instructive. Taken together, what they seem to suggest–I want to say “prove,” but I’ll refrain–is that the collective response of a group to any question of knowledge is going to be both the best response possible (the Oscar example) and a remarkably accurate response as well (the IBM example).

If the question in the case of the stock market, then, is “Which companies have the greatest long-term value as businesses?”–and this is the basic question, even if it gets framed in other ways–then the market’s answer to that question is, much more often than not, going to be right, as it has been, and is, in the case of Dell, Microsoft, Coke, Gillette, and Wal-Mart.

This doesn’t mean that markets are always right, which is to say that it’s not exactly just a restatement of efficient-markets theory. For instance, it often takes time for the market as a whole to recognize a company and think seriously about its business model and its valuation. (Which is why if you’d bought Dell in 1996 you’d be reading this on a yacht.) But there’s a more important reason why markets aren’t always right, too. Experiments like the ones that Mauboussin does work best when all the actors make their guesses independent of what everyone else is guessing. In other words, neither the IBM nor the Oscars experiments would work if people shouted out their answers one by one, because hearing the answers of others would shape the decisions of those that followed.

But in the stock market, of course, people are always shouting out their answers, both in the form of the stock ticker but also on CNBC and on and here in Moneybox. As a result, the market is subject to manias and panics, which you might define as periods when investors are only worrying about how everyone else is answering the question, instead of what the right answer is. In the long run, though, the right answer is what the market cares about, which may explain why someone like Warren Buffett is a great investor, since the right answer appears to be the only thing he cares about.