Professor and Author
"Outsmarting the Smart Money - Understand How Markets Really Work and Win The Wealth Game"
Transcription of Audio Interview, June 8, 2002
Editor's Note: We have edited the interview in this transcription for clarity and readability.
JIM PUPLAVA: Joining me on the program is Professor Lawrence Cunningham. He has recently accepted a new position as Professor of Law and Business at Boston College, having previously served as Professor of Law and the Director of the Heyman Center on Corporate Governance at Cardozo Law School. His other books include the internationally acclaimed and best-selling titles The Essays of Warren Buffett: Lessons for Corporate America and How to Think Like Benjamin Graham and Invest Like Warren Buffett. He is here today to talk to us about his new book Outsmarting the Smart Money - Understand How Markets Really Work and Win the Wealth Game. Professor, in your studies on Warren Buffett and the investment markets, you talk about how a long-term, value-oriented investment philosophy offers investors superior returns to investing in the stock market. Is that true?
LAWRENCE CUNNINGHAM: Yes, that’s the real payoff from my book, Jim. In one of the final chapters I talk about what I call “investor evolution." It's a struggle that you see many investors, and their investor class as a whole, going through over many generations. We all struggle with short cuts and tricks and hot tips and so on. We eventually learn that most of these short cuts don’t work out so well. In fact, taking them can often compound problems rather than compound value. So, I think that that’s right.
Once you examine the way most of us behave and perform over short periods of time, and the whole population performs over short and longer periods of time, I think that you’ll see that the best way to get our behavior under control and to discipline ourselves is to have a long-term, value-oriented philosophy. I think most of the first half or two-thirds of Outsmarting the Smart Money makes the case for the difficulties and challenges that investment decision-making pose for all of us. The final chapter sort of synthesizes the better techniques that will help produce superior returns. When you line all those up, they are hallmarks and characteristics of the long-term, value investment philosophy championed, most notably, by Ben Graham and Warren Buffett.
JIM: In your first chapter you talk about this gap that exists between how people behave and how economists presume they behave. Explain that.
LARRY: This is a foundational chapter in which I explain that for the past thirty-plus years, the dominant teaching in the American academy and the dominant theology on Wall Street has been the Efficient Market Model. This is the idea that through a lot of people paying very close attention to companies, business and financial data, that the price of a stock is the best indicator of the value of the business it represents. This story assumes that there are enough rational, purely rational, actors in the marketplace who always get things right.
From this, Wall Street analysts and business school professors have developed a wide range of techniques to talk about stocks, including things like their beta, the degree to which the price of the stock varies compared to the overall market. They are tools for defining how risky a security is and as tools for defining what a proper collection of stocks would be for their portfolio. A lot of lessons have gone forward based on this view of how markets work that have been developed over the last thirty years.
This book is about a very different view of markets, in which people are infected by all sorts of irrational behavior. We are often overconfident. We see patterns that don’t really exist. We are excessively adverse to losses and a variety of other behavioral ticks that infect us all, the dumb, the smart, the smarter and the smartest. All of us, as human beings, are prone to these behavioral limitations and the aggregate of this behavior also affects the pricing of stocks in public capital markets. So the result is that prices deviate from values. This is the opposite story then. This is a story that is now gaining prominence among business school professors and many, though hardly a majority, on Wall Street as a school called “Behavioral Finance� or “Behavioral Economics�. And it simply tries to be more realistic about how people behave and what that means for how market prices operate.
JIM: Isn’t this one of the problems that we have seen in terms of, let’s say, the demise of hedge funds like Long-Term Capital Management? That so much of Wall Street and some high-powered money managers have grown up on this Efficient Market Thesis and that they’ve learned to define risk as a measure of volatility rather than, for example, leverage.
LARRY: I think that’s exactly right. I talked about Long-Term Capital market in the book as an example of a situation where even the brightest of the brightest, I mean the folks running that hedge fund included Nobel Prize winners and former senior officials in the Treasury Department, they developed a bunch of economic and investment models based on assumptions about rational economic actors and efficient markets and then detected pricing discrepancies of various securities, mostly bonds, around the world that were a little bit out of line according to their model, and that should have reversed in fairly short order, according to their models.
Well, it turned out, their models might have been terrific if everyone were behaving rationally, but, in fact, what happened in late 1997 and through 1999 is markets went berserk. A financial crisis broke out in Japan. The Russian government devalued the Ruble and markets all around the world went nuts, against the way that the model predicted things would work. The result was these fellows lost an enormous amount of money. And, right, they were looking at risk according to their models which is the degree to which various prices are going to move compared to benchmark prices. In fact, the main reason why the company went completely under was because they had taken a relatively modest amount of capital of their own, a billion or so, and borrowed a hundred times that. When they began to lose money this sort of leverage effect worked in reverse. It worked as a pump and caused them to be unable to pay their obligations as they came due. So they got a dose of behavioral economics, of how markets really work, of how people really work when surprising economic conditions arise. So the Nobel Prize winners at Long-Term learned the real lesson the hard way. The theory is wonderful, the models are pristine, but it’s not really how markets work or people behave.
JIM: Now, in your book, you also have a chapter about a long-forgotten school of economics, which was the Austrian school. I wonder if you might discuss the role of Austrian economics and explain how markets and economy work.
LARRY: The Austrian School has been sidelined in the history of economics. Most people will probably recognize the name of Friedrich Hayek, who was one of the leaders of the Austrian School. He won a Nobel Prize in economics in 1974 for his account of the complexity of economic variables and the social context in which economic activity goes forward. But, while he and dozens of other great, great thinkers from the 1850’s through about the 1940’s or so, had developed a very elaborate theory or philosophy of economic behavior that focused, that zoomed in, on the behavior of individual people. This Austrian School thought, to understand overall economic activity at the macro level, you really needed to understand individual economic behavior at the micro level.
So they said, look, the economy is just the aggregate or the sum of all individual actions, so in order to understand the economy, you have to understand individual actions. And, when these fellows examined individual behavior, they saw the kind of deviations from pure rationality that I was just talking about, overconfidence, seeking patterns that don’t exist, being excessively loss adverse, and so on. This group of theorists really began to develop a story of economic behavior that included messy decision making and complex interdependence of lots of variables. The story that, as our last century rolled along, American economic theorists didn’t really take to it.
They [American Economists] began, instead, to develop abstract mathematical models of the kind that led to the Efficient Market Theory, which tried to look at overall economic pictures. It tried to look at markets in equilibrium, that said, well look, let’s not worry about the messy behavior of individuals at that micro level. Let’s look at the system as a whole and the process that all this individual action leads to. By focusing on this sort of abstract level, American economists developed a whole different way of looking at the world.
The Austrians were left in the dust bins of history. Hayek is most famous today for his view about the proper role of government in setting the conditions for economic activity. His stance, followed by other Nobel Prize winners such as Milton Freedman, advocated relatively modest, limited roles for government. This group argued that individuals are better at making decisions that affect their own lives than government is. Not because they’ll always get it right, but because they’ll get it right more often than the government. So, Hayek and the Austrian School have come to stand for this sort of Libertarian view, this philosophy of government. Their more important contributions, which are direct contributions to the economic thought, economic behavior, have been relegated to the sidelines. I think the good news is, and the reason I start out the book with an account of the Austrians is, their philosophy is making a comeback. Their theory of economic behavior is making a comeback. In a way, I think this book is really one of the first to make this link, but I think that they furnish a very strong sort of intellectual ancestor to current theories of behavioral finance.
JIM: Do you think that’s a reflection of, perhaps, the failure of Keynesianism to explain how the economy works efficiently in the markets?
LARRY: The resurgence of the Austrian school in the economic theories?
LARRY: Yes, I think that’s probably right. I mean that’s a very nice point Jim. I think one of the reasons why the Austrians were left on the sidelines, at least as far as their stories about how economic activity occurs and the role of individuals in it, was the overpowering successes of Keynesianism in the 30’s. At that time, governments all around the world were struggling mightily with Depression and no one seemed to have any really good answers about the causes of depression or the solutions, the ways out. At that time, Keynes came along with the cure of government spending, including government deficit spending and many countries around the world, including the United States, followed that prescription. It seemed to have worked, or at least there was enough coincidence with increased economic expansion and so on, that Keynesianism carried the day. Government spending and deficit spending have been an important part of every capitalist society’s government since that time.
Now, as you suggest, there are certainly plenty of reasons to be skeptical about that as the solution to social or economic ills. I think there is at least a good argument to suggest that people are becoming reacquainted with the Austrian School for precisely that reason. I think, though, what’s interesting, in terms of investing or the implications for investing, is that those economists and business school professors who are now developing behavioral finance, is that stories of stock market behavior that show inefficiencies and so on, haven’t really consciously drawn on the Austrians yet. As I suggest, I think that this chapter in my book is one of the first places where you see this connection drawn out. I think that there is increasing attention being given to the Austrian School and I’d like to see the behavioral theorists turn to it as well.
JIM: Let’s talk about the role that investor sentiment plays in the market. You’ve written a chapter about that. Explain what it is and why it’s important.
LARRY: Investor sentiment refers to -- a professor at Harvard Business School, Andre Schleifer, is to be credited with coining that term -- signifies that our individual moods, feelings, and emotions of investors have an important role to play in the process of capital allocation and capital formation and market pricing that we see everyday in the marketplace. That is, investors may be excessively moody one day or excessively giddy another day and those feelings, those moods, will have an effect on stock prices everyday. Again, this is one of the dominant contributions of behavioral finance. It sounds very common sense. It sounds obvious in a way. How we all feel may affect the level or the values that we place on assets. But, the contrast is with the efficient market story, which says, oh well no, the market at least, will behave as if everyone is acting purely rational and not succumbing to sentiment. Not pricing things too high when we’re giddy and happy, and not pricing things too low when we’re more pessimistic and depressed. So, that’s the sense of the phrase “investor sentiment�. In this chapter, I identify about a dozen different major causes or illustrations of investor sentiment -- the kind of behavioral tricks in the parlance of the literature. I also discuss the cognitive biases that we, as investors and as people, suffer from, and how those cognitive biases affect market prices.
JIM: Let’s talk about the role of arbitrage. We have seen and you have written, that we often experience substantial and sustained periods of time where we have deviations between the price of a security and a value. In other words, we may experience periods of over value for securities as we did certainly during the mania phase of the latter stages of the bull market and also long sustained periods of under value as certainly we saw in the late 70’s.
LARRY: I think that’s right. I think we may well, in some quarters at least, be seeing some of that under valuation even now. My guess is we may see that for quite some time to come. You would think that if there is a consensus or if there’s some objective truth to a condition of over valuation that arbitrageurs would recognize that and sell short the market or a bunch of stocks in the recognition that that will eventually correct itself. Conversely in situations such as perhaps certainly the 70’s, perhaps now, arbs would recognize that stocks are under valued and would immediately enter the market and stocks and both of these responses would have the effect of restoring the price-value identity. Indeed this is the engine of the efficient market story. It says that, well, it may be the case that there’s some investor sentiment that poisons perfect market pricing, that drives a wedge between price and value, but there are sophisticated arbitrageurs monitoring those deviations so that anytime they arise, they will step in and correct those inefficiencies and reverse them so that you get a steady state of market efficiency.
Well, I think, obviously the premise that you just suggested that you have occasional bouts of overpricing followed by bouts of under pricing, so that this perfect arbitrage story is at least not wholly accurate. I devote a chapter to suggesting why arbitrage is limited in this way. I use the phrase limited arbitrage, again a phrase that Andre Schleifer, I think deserves credit for coining. One of the reasons why arbitrage is limited in this way is that the arbitrageurs themselves, sophisticated though they may be, suffer from exactly the same kinds of behavioral limitations that all the rest of us suffer from, including overconfidence and pattern seeking and so on. You can’t count on them to behave in the perfectly rational way that’s necessary either. Also, even those who are most insulated from that kind of behavioral and biased action, face risks that the rest of the market won’t come around in time. They may be behaving perfectly rationally, buying stocks when they seem under priced or selling them short when they seem over priced, but there’s no guarantee that the correction that they rightly perceive will come any time soon. They can’t move markets all by themselves.
I give the example in this chapter of Long-Term Capital Management, where I at least present the case that the arbs at Long-Term Capital Management were acting utterly rationally and that their models were actually right in terms of what the proper price of the bonds that they were trading would have been -- given reasonable discount rates and fair estimates of cash flow -- but, that everybody else in the market was acting weird. And that’s why the market remained berserk. It remained berserk and mis-priced for a sufficiently long time so that Long-Term couldn’t cover it’s positions in time and it had to fold up its tents. So, arbitrage is a very risky business, even for the purely rational, the smartest of the smart money. And there’s just not all that much smart money out there to correct the mistakes. So you’re going to continue to see persistent price-value deviations.
JIM: Let’s talk about some of the mechanics that you talk in the next section of your book. And I want to talk about the role of share buybacks. Certainly they were touted as a great thing for shareholders in the late 90’s, but as we’re beginning to find out now, with all the impairment charges, this turned out to be not only a dilution of shareholder value, but a destruction of that value. Talk about the role of share buybacks, good and bad. And then I want to move on to what were seeing today as so much corporate spin, or what you call, "Corporate Ebonics."
LARRY: I think there’s an interesting history of share repurchases that I recount in the book. There were several waves over the last 20 or so years that saw an up-tick in the use of share buybacks. And look, at a general level, there’s a very good argument. If I’m right and the behavioral finance story is correct, so that it is possible that a stock can trade at a price that’s lower or greater than its value, well that means that there are some arbitrage opportunities at the company who issued that stock. So that, if the price of a company’s stock is lower than its value and the company has additional excess cash that it can’t find superior opportunities to allocate that cash to, a wise use of that cash may be to go ahead and buyback the stock. This would be a way to return capital to investors. It would be a way to return capital to the shareholders where they get to decide if they want to receive a cash return in exchange for a piece of the equity they own. Investors that don’t wish to incur the tax consequences of that can sit out. Those that would like to make an exchange of their equity for some cash can do that. So, there’s a wisdom to share buybacks if properly done and a strong benefit to shareholders. This is only wise and only desirable to the extent management is also communicating its beliefs honestly and accurately to the shareholders about the price-value relationship.
Likewise, when things are the other way around -- that is when stock prices are high compared to value -- that is certainly a good time from the company’s point-of-view to sell new shares. I spend a fair amount of time in the book talking about that and its consequences for investors. But, as rational and sensible and desirable as it is for companies to buy back shares when their prices are below their values, what you saw in this most recent wave of share buybacks and increase in the volume and extent of share buybacks, it all occurred or much of it occurred at a time when it was pretty clear that prices were above values. So it’s not so clear that management was acting in a shareholder -friendly manner. Indeed, during the most recent wave of share buybacks, there was a simultaneous increase in the level of stock options being granted to managers. Indeed the exercise prices that managers had to pay to acquire this stock were substantially lower than the trading price of the stock at the time. What you got was a sort of a shift in the ownership of big pieces of major public companies from shareholders to managers in a process where the shareholders lost and the managers gained. This was a very pernicious, game of musical chairs and I make the joke in the book that, what the wise do in the beginning, fools do in the end. I mean, share buybacks certainly have a place. They’re very useful and can still be very useful in a certain context, but I think they were also abused in the past several years.
JIM: Let’s move on to something I think investors really need to made aware of. You cover this quite extensively in your book. That’s the corporate spin. We’re getting ready in the next four weeks to come upon the second quarter earnings season. I call it the quarterly earnings game. We see so many numbers that are bandied about by analysts, anchors or company CEO’s when they talk about their earnings (and they’re anything but earnings.) They’re talking about, you know, usually in most instances, proforma numbers which can be anything that management want them to be.
LARRY: I come down very hard on that quarterly game you mentioned. I think you’re right to call it that, Jim. I’ll say at the outset that I think that this game is enabled, to a large extent, by excessive belief in efficient market theories. In other words, if the market really is efficient, that it is simply accurately pricing business value, then it might be fine for all of us to focus on a single bottom line figure. I mean, after all, if we’re going to say if GE is priced at 50 that’s what it’s worth, then we only need to look at that number and maybe look at the earnings number. We can distill it. We can reduce everything down to some single number. This leads to a massive evasive fixation on bottom line figures. Well, when that happens, you "incentivise" managers to manipulate that number. There's an old phrase: "We manage what we measure." Well, if we’re measuring earnings per share, let’s get those earnings per share equal to $2.00 or $2.10 or $2.20, whatever.
So I think the efficient market story is, in part, to blame for this fixation on earnings and this very aggressive accounting environment that we’ve seen in the last several years. It would have been better if we had all recognized, as is true, that the steps that we take in getting to that bottom line number are as important, probably more important, than that bottom line number. If we were all able and consciously focus on when revenue is recognized, when expenses are recognized, what expenses are recognized, I think the culture would be far better off and we wouldn’t fixate on the bottom line numbers and we’d have less emphasis on things like proforma data. We’d emphasize the timing of revenue recognition and so on. I’m not saying that you wouldn’t still have managers playing games, but I think the culture would be far more conservative and more focused on the substantive steps of getting to a report rather than the bottom line of that report.
JIM: Let’s talk about the role that emotions and the mind games that we all have to be made aware of as investors. I think you quote the economist, Irving Fisher, on the most important habits.
LARRY: Yes, I think this is part three of the book. Given that I analyze investor sentiment and show how each of us and all of us as a group suffer from various behavioral limits and cognitive biases and so on, in this part of the book I try to turn attention to how we can address and overcome these limits. So, in this chapter on mind games, I try to just dramatize the context by looking at series of financial scams starting with Charles Pond, the classic manipulator of people’s minds, and how scam artists and financial fraudsters can use our psychology against us. So I begin with that sort of drama to underscore how it is that we all can suffer from this, and in that chapter in particular, I show the so-called smart money, William Simon, former Treasury Secretary, Lawrence Rockefeller, the Scianos -- one of the greatest financial families, got sucked in to recent financial scams. So even the so-called smart money suffers from these things and I try to identify from these gigantic scams several key things that investors should be alert to in their own thinking about investment decisions.
JIM: How important is it to learn to come to grips with control of our emotions as investors?
LARRY: I think that’s the number one thing in a way, Jim. You started by asking about whether being a long-term, value oriented investor is the sort of ultimate philosophy or the ultimate way to solve the problems I identify in the book. I think that’s all about getting emotions under control. The epitome of rational investing is the Warren Buffett model -- the Ben Graham model -- where these fellows conduct hard-headed business analysis about the intrinsic value and economics of an operation. They try not to be swayed by the glitz and the glamour and the noise. They try to get their emotions utterly under control and try to be as rational as humanly possible about analyzing the economics. So, I think that’s probably the number one thing. It’s very difficult to do and there are a lot of strategies. I suggest a dozen of them to help achieve that rationality, that is getting emotions under control, but I think it’s the number one thing.
JIM: And, finally, Professor, If you were to conclude or summarize your book, if there was one important lesson that you would want investors to walk away with after reading your book, what would that be?
LARRY: Know yourself. I think it’s the last sentence or two of the book, but what this is all about is recognizing that each of us has a little different psychological make-up, a little different emotional plane, a little more or less aversion or appetite for risk. Being aware of our own composition, our own chemistry, our own outlooks and stuff is essential. Maybe it’s not even as hard. It’s not just about investing. It’s really about life. So, know yourself and identify the places where you need a little bit of work or help, or maybe confer with someone else who has the card that you don’t have. So I think knowing yourself and knowing your own psychology is probably the number one thing.
JIM: Well, Professor, I want to thank you for joining us on Financial Sense Newshour and being so generous of your time. The name of the book is called Outsmarting the Smart Money-Understand How Markets Really Work and Win the Wealth Game. Professor, thanks once again and I highly recommend your book as a companion piece to your previous book which was about Warren Buffett and Benjamin Graham.
LARRY: Well, thanks so much, Jim. It’s great to be here again.