Making Peace With Ponzi

Fool undies in a bundle
You might not realize it from our flip-flops-in-the-office attitude, but the folks at Fool HQ aren't entirely immune to the occasional knicker-twist.

Last week, we had a doozy when a Web commentary from Dallas Mavericks owner Mark Cuban -- most famous for his well-timed cash-out to Yahoo! (Nasdaq: YHOO  ) -- attacked a few of the principles that many Fools hold sacred. In short, he said, or at least strongly implied:

  1. Brokers and mutual funds are full of it.
  2. Buy-and-hold investing is a sucker's game, especially in mutual funds.
  3. The market is a Ponzi scheme.
  4. There's no way a little guy, without an information edge, can outperform.

Back here, elephants stomped. Emails flew. Tempers flared, and we even got a rebuttal, of sorts, from Rick Munarriz. Rick's handled the mutual fund side of things, so I'll let that one lie.

I figured that there ought to be a Fool among us to come out and take the other side, which is this: Cuban's really not so full of it. If you consider carefully where he's right and where he's wrong, you have a pretty good recipe for beating the market, even if you're a little guy.

Ponzi and the plankton
Here's my first nod to Cuban. He's right about funds and brokers, or at least the vast majority of them. They're looking out for their own pocketbooks first, and on the slim chance they're not, it costs you nothing to assume that they are and do your own thing anyway.

Another nod to Cuban: Much of the market is like a giant Ponzi scheme. There are scads of companies out there, especially those promising the Next Big Thing, that produce no cash on their own. What they survive on comes from promises to investors, who dump money in when the press looks good and hope that those feeding them the information -- analysts, stock promoters, the companies themselves, whoever -- aren't choking them with a line of bull.

Often, they are being sold dreams that never materialize, but in the long run, there's a never-ending supply of low-level plankton to feed the big fish further up this chain. How else can you rationally explain people rushing to own pieces of long-term serial money-losers like broadband blimpsters GlobeTel or Altair Nanotechnologies (Nasdaq: ALTI  ) ?

Among these spicy meatballs, even companies that turn profits, like Travelzoo (Nasdaq: TZOO  ) , become traders' playthings, flying upward beyond any rational expectation for their growth or real returns. Everyone's happy. Everyone's screaming "Booya!" Everyone's an expert! Until the supply of suckers dries up. Then it's look out below.

This is why it is very tough to argue with Cuban's contention that, absent an expected cash payment, like a dividend, a stock is pretty much nothing more than a baseball card on the schoolyard. It's worth only what you can convince the other shmoe to cough up, and that's likely to depend a lot more on what the public perceives the company's fortunes to be -- Apple (Nasdaq: AAPL  ) is the king of the world! -- than on a rational valuation.

Of course, a healthy dividend is great, but I don't always demand one. If a company earns sufficient cash flow and deploys it in ways that benefit me as a shareholder, I can be more than satisfied. And in many cases, I'm investing in firms that pay a smallish dividend because I expect those will keep increasing in the future, on the back of those strong cash flows. Either way, I look for real cash generation. If it's not being squandered by greedy management (as it often is, of course), eventually the market will recognize this and the stock should appreciate.

Where's your edge?
Where I part ways with the Cuban argument is on the contention that an investor needs an information edge to make a buck with stocks. This is elitist, short-sighted, and wrong in my experience. I don't buy it for a second, and here's why. I watch stocks. I invest in stocks. I know only what everyone else knows, and I make a habit of beating the market.

You need only look at the yearly mood swings on just about any stock to see how this is possible. Firms like Abercrombie & Fitch (NYSE: ANF  ) or Lowe's (NYSE: LOW  ) make it easy to see what I'm talking about. Was there a material waggle in the results of these businesses over the past year? Did anyone know anything more than anyone else at those points in time? Not so much. But there were swings of 25% to 50% in the stock prices.

That's opportunity for big returns, if only you could muster what? More information?

Wrong. All you needed was the courage to see what was there and the guts to buy when it wasn't popular.

Foolish bottom line
You don't need an information edge. You need an emotional edge.

Stocks move simply because people freak out. Mr. Market overreacts. All the time. Case in point: Is Intel (Nasdaq: INTC  ) really worth 12% less today than it was a couple of days ago? Hmmm.

And when the market overreacts, I make my money. Because I don't freak out. (Not usually.) This, by the way, isn't some revolutionary idea. It's how Buffett and Munger, Whitman, Neff and many others have done the same. And it's the way my colleagues at Motley Fool Inside Value look for their stocks, too.

We tend to hunt in different turf -- I prefer retail because the freakouts are more frequent and more extreme -- but the method is the same, and it's simple. When you pick stocks with solid businesses, relatively predictable cash flows, and a history of doing right by investors, you can put a value on the stock, separate from what the baseball-card traders are willing to pay. Then, you buy at a discount.

Is the market a Ponzi scheme? Sometimes. But if you play a different game and buy real goods when the market is ignoring the obvious for the next pyramid scheme, you have all the odds you need to win the game. You don't need to be a genius, and insider, or even a Cuban. All you need is guts and maybe a little guidance. You can get a dose of each with a free trial to Inside Value.

Seth Jayson is a great fan of paying less than retail. That's why he knows his shopping preferences are a contrary indicator in the retail space. At the time of publication, he had no positions in any company mentioned here. View his stock holdings and Fool profile here. Fool rules are here.


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