Greetings from Molfetta, Italy! Before I get to the main topic of today's column, allow me to tell you about this coastal region on the Adriatic and why I'm here.
I'm spending a week in this town in the southeastern part of the country vacationing with my family and teaching a seminar on value investing. This region of Italy, called Puglia, produces most of the country's olive oil and pasta and has a fascinating, ancient history -- we've visited gorgeous castles and cathedrals that are nearly 1,000 years old. And if you're looking to get off the beaten path, this is it. We have yet to encounter other Americans. While I highly recommend Rome, Florence, and Venice, running into busloads of tourists every five minutes gets old.
Our host is Francesco Azzollini, who has established a value-oriented investment fund here -- the first in Italy, he believes. He taught himself investing by reading all of the classics and sitting in on classes taught at Columbia Business School. He's been applying those lessons with a great deal of success, compounding money at 18% since the fund's inception in 2000. He invests primarily in the same situations as U.S.-based value investors: out-of-favor companies, stubs, post-bankruptcies, etc., that trade on the American stock exchanges (though, not surprisingly, he also dabbles in Europe). It's fascinating and heartening to see that the gospel of Graham, Dodd, Buffett, and Munger has reached this remote corner of Italy.
Francesco's success underscores two important points about value investing. First, one can become a skilled practitioner of the craft without following the typical route of getting an MBA and then apprenticing at a fund. In fact, given how poorly investing is taught at most business schools and practiced at most funds, one might be better off without these experiences!
Second, the importance of having access to company managements and making site visits is way overblown. In fact, this too can work against an investor's interests. (There's an unfortunate amount of truth to the joke about how can you tell when a CEO is lying? His lips are moving.) Through the Internet, Francesco can access all of the information he needs to make informed decisions, and his remote location isolates him from the sound and fury (read: nonsense) of Wall Street. You can be sure that CNBC (Bubblevision) isn't blaring in his office, and since the U.S. market doesn't open until 3:30 in the afternoon here, he has nearly the entire day to read and do analysis. Hmmm... Maybe I'll just stay here...
Back to our regularly scheduled programming...
I've long believed that investment success requires far more than intelligence, good analytical abilities, proprietary sources of information, and so forth. Equally important is the ability to overcome the natural human tendencies to be extremely irrational when it comes to money. Warren Buffett agrees, commenting that, "Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ... Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing."
Investing for the birds
With this in mind, let's examine an experiment done with pigeons that I think provides insight into the bizarre investment behavior I observed in my January column, A Scary Time for Stocks: "It's mind boggling that so many investors are piling back into the same sectors that crushed them only a short time ago, like moths drawn to a flame." My lament prompted my friend Peter Kaufman, a board member of Wesco Financial
Your observation made me think of classic behavioral research of the 1950s, which employed rats or pigeons to determine how thinking creatures react to certain situations. One such research project, "Pigeons at a Feeding Bar," may offer some insight into this "moth-like" tendency of investors to return again and again to the same bad situation.
In one stage of the research project, pigeons are first acclimated to a set pattern of food rewards, in which the pigeon "earns" his kernels by pecking a feeding bar until a unit of food is delivered (for example, the pattern might be for one kernel after every 10 strikes of the bar). Subsequent to this particular pattern being established, food delivery is terminated altogether, allowing researchers to tabulate how long a pigeon will continue to hit the feeding bar before it realizes it has become fruitless to do so. The research revealed that pigeons are, as a group, remarkably consistent in the time that elapses until they realize that a formerly productive pattern has been replaced by a new, fruitless one. Once pigeons rationally discern the true pattern, they uniformly abandon the process in a predictable and timely manner.
But what happens if no true pattern of reward ever exists in the first place? For example, what happens if instead of an established pattern of rewards, the feeding bar reward sequence is purely arbitrary (i.e. a random number table is used to set reward intervals)? Under this scenario, the poor pigeons encounter a mind-spinning quandary: Although they see there are alluring rewards to be had in the system, they are unable to grasp how those rewards can be consistently earned. The amazing result: In random-number versions of this experiment, even after the food delivery has been terminated altogether, pigeons return again and again, relentlessly hitting the bar until finally they drop from physical exhaustion.
What relevance do pigeon studies of the 1950s have to Wall Street behavior in 2004? Well, at the risk of overdrawing animal behavior to human behavior, investors repeatedly returning "to the flame" sure looks a lot like the behavior of lab pigeons in the second version of the experiment. And the reason appears to be the same: Both the investors and the pigeons are mesmerized by the tasty rewards they believe lie within the system, and both are similarly unable to divine a recognizable pattern as to how such rewards are earned at the feeding bar.
Should investors' inability to grasp a recognizable pattern really surprise us? Investors have watched in bewilderment as an entire investment hierarchy has thrown out basic accounting conventions and valuation metrics that have been in effect for nearly a century; they have seen initial public offerings soar to the stratosphere for companies with no comprehensible business model, no cash flow, and sometimes, even no revenue; and they continue to see CEOs drive their companies into the ground while nevertheless receiving tens or hundreds of millions of dollars of stock options. Is it any wonder why investors are unable to identify a recognizable, dependable pattern as to how rewards are to be earned in this system?
Researchers learned that pigeons, faced with alluring rewards but without recognized patterns as to how they are earned, essentially go mad, incessantly returning to hit the bar until they physically collapse. Sadly, in environments such as market bubbles, it seems this same stimulus-response mechanism can apply to human beings. Just as is the case with slot machines, lotteries and other forms of unskilled gambling, when investment returns take on the character of being arbitrary, unearned, or random, human hope springs eternal -- rendering many investors unable to resist the feeding bar.
Can anything be done to stop this recurring insanity? As the lab pigeons showed us, the only real antidote for irrational investor behavior, is rationality (i.e. the ability to truly understand what is going on). In other words, the antidote for market bubbles is rational pattern recognition, recognizing that the valuations of the securities they are snapping up have no basis in future earning power or any other objective economic measure, but instead have a basis in grossly unrealistic claims, promotions, hopes, and dreams.
Is there any hope that the irrational exuberance bemoaned by Alan Greenspan in December of 1996 will evolve into a saner set of investor behaviors? I'm not holding my breath. Human greed and wishful thinking, time tested as they are, suggest that most human investors will never be anything but pigeons.
Translating theory to practice
I think my friend is exactly right, and his conclusions are supported by other studies conducted by Vernon Smith, a professor at George Mason University who shared in the 2002 Nobel Prize for economics. As described in TheWall Street Journal on April 30, in numerous experiments he conducted, "participants would trade a dividend-paying stock whose value was clearly laid out for them. Invariably, a bubble would form, with the stock later crashing down to its fundamental value." One would think that the participants, having suffered horrible losses, would have learned not to speculate. Yet when they gathered for a second session, "still, the stock would exceed its assigned fundamental value, though the bubble would form faster and burst sooner."
How could another bubble form so quickly? Simple: The take-away lesson investors learned the first time was not "don't speculate," but rather, "it's OK to speculate, but one must sell more quickly once the bubble starts to burst." Sound familiar?
Of course this game doesn't work either, since few people can accurately time the top and everyone tends to head for the exit at the same time. Professor Smith notes that "The subjects are very optimistic that they'll be able to smell the turning point" and "They always report that they're surprised by how quickly it turns and how hard it is to get out at anything like a favorable price."
Thus, it is only when Professor Smith runs the session a third time that "the stock trades near its fundamental value, if it trades at all."
I would argue that in many sectors, we are in the midst of the second mini-bubble and that speculators will be crushed again. Investors -- and pigeons -- beware!
Contributor Whitney Tilson is a longtime guest columnist for The Motley Fool. He owned shares of Berkshire Hathaway at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool is investors writing for investors.