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Thursday, September 16, 1999

The following article originally ran as a Fool on the Hill
article on February 11, 1999.

The Misunderstood Market

By Dale Wettlaufer (TMF Ralegh)


The market is a complex adaptive system that very often eludes very simple cause/effect explanations as to why things are moving. Individual insights, in and of themselves, into why something is moving are less often useful than a collection of insights can offer.

Analyst Michael Mauboussin offers an explanation of this truism by drawing a parallel between market efficiency and the behavior of migrating birds. Migrating birds have no leader, though species such as geese fly with what appears to be a leader. That bird does not happen to be a leader, in fact. There is a collective intelligence at work that leads the geese to warmer climes, not some wise bird out front. Oftentimes, market price setting works in such a way.

The interaction of the many players in the market, each of which has its own opinion as to the factors that decide the value of a company, functions in the same way as migratory birds. It might not look as orderly as a gaggle of geese flying chevron formation, but that's because we overlay the notion of orderliness on what those birds are doing. The market's moves here and there are chaotic in appearance, yet they are ultimately highly efficient in setting the right prices for
companies.

In the short-term, this might not appear to be the case, depending upon the way you understand the value of some companies. eBay (Nasdaq: EBAY) looks completely ridiculous to some people (who can't help themselves from saying so vehemently on CNBC). If you look at today's price-to-sales ratio in a vacuum, not looking at the company's sales growth rate or the economics of how it generates earnings, naturally you will proclaim it ridiculous if your investment universe consists of cheap, beaten down companies. Seriously, people look at eBay and ask why it's so expensive compared to US Steel (NYSE: X). I actually heard that one the other day.

People will give you all sorts of explanations for eBay, some of which no doubt hold value. These include the reasons that its float is very small, the shorts keep closing out positions at huge losses, individual investors have gone off the deep end, etc. It seems like the commentators that cry "tulip" never proceed from the hypothesis that maybe there is a good reason why eBay is priced the way it is or why Amazon.com (Nasdaq: AMZN) is priced the way it has been.

I won't argue why eBay is undervalued or overvalued, though I think there are good reasons why it should be valued in the multi-billion dollar range (that doesn't mean I do or do not believe its current price is right). It just seems to me that in the mass media and even in many alternative media outlets, the "tulipmania is here" view is the only one expressed. How many times have you seen a local newspaper guy or a financial TV network commentator ask in the fashion of the true skeptic if eBay is undervalued? I've never seen it.

There are obviously market participants that believe eBay has been undervalued or represents a fair value. Mary Meeker at Morgan Stanley is a fan, and evidently so are some of her clients. But she's an analyst. She's not part of the media. When you are part of the media (and don't take this to mean that I think I am, because even if I am a member of the media, I do not think of myself in those terms whatsoever), you've got to come up with these cause/effect explanations every day. In a chaotic, complex world, one person's view of a single cause/effect in the pricing of eBay or things like it really doesn't mean much. That includes the "tulipmania view."

Consider what Federal Reserve Board Chairman Alan Greenspan said in his explanation of Internet stocks. To the ridiculous question one senator posed -- something about the "principal" retirement investment vehicle of Baby Boomers being Internet stocks -- about what was happening with these stocks, Greenspan said simply and most correctly that the market is a highly effective capital allocation machine. As the primary vehicle of the expression of the economy's valuation of its publicly-traded companies, in the world's most efficient economy, it's wrong to assume that only a horde of day traders with itchy trigger fingers are the people driving prices in this segment of the market.

What Greenspan said is that most of these companies will do poorly. I wouldn't disagree. Most publicly traded companies have historically managed to add little to no value to the capital invested in them. Many subtract value from invested capital and few add lots of value. What Chairman Greenspan said isn't new and is not an indictment of any kind. It's a simple statement of fact.

We all have models in our heads that allow us to look at the world in a rational way, but it's disappointing that many people with access to the media -- whether they're investors, anchors, or whoever -- have decided there's only one reason why Internet stocks all trade at the value they do. There are numerous reasons why something like eBay trades where it does and numerous ways it can also lose value, neither of which I consider to be the presence or the eventual non-presence of a speculative bubble.

I won't tell you why I think that is. I don't need to, either. The market already has. Every day it expresses a collective intelligence that updates the price of the company. In the short term, the collective intelligence can fly off course. But over the long run, the collective intelligence of the market has been more than proven. The longer the Internet leaders stay up (by this, I mean relative to the capital invested in them, not relative to the price at which they traded yesterday or last year), the less like a bubble it looks and the more it looks like the result of a rational, complex pricing mechanism.

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