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Value is created in the mind – which helps explain financial markets

12th July, 2021

Published in the Sunday Times on 11th July 2021.

It was thought to have originated in US summer camps in the 1970s. One theory says it was invented in 1975, as Steven Spielberg's Jaws became a box office smash around the world. But for the version you will be most familiar, it all started with Ryan Lee,  co-founder of a South Korean media startup, believing there were too many harmless animals portrayed in children’s music: why not have a song about a fierce animal such as a shark he mused? 

Five years on and “Baby Shark”, the excruciatingly catchy tune about a youngster and its family, has been played more than 8bn times on YouTube, making it the platform’s most-viewed video. SmartStudy, the South Korean kids music company that Mr Lee co-founded a decade ago, made a multi-million dollar fortune from the company’s copyrighted rendition of the song. According to the Financial Times, the company has a private valuation of about $1bn and is rumoured to be considering a New York stock market listing.

The perception of value

Value really is created in the head, not on a spreadsheet. The extent to which a product or service (or a song) delivers value is dependent upon people’s perception, rather than on any objective assessment of its characteristics. Call me a curmudgeon, but any objective assessment of the quality of Baby Shark that ventures anything more positive than ‘annoying’ deserves ridicule. It sparked a thought however. Is this a useful mental model to account for some of the goings-on in financial markets, particularly over the last 12 months? 

There’s a whole swathe of assets that defy valuation based upon objective assessments of their characteristics. I’ve been trying to understand the whole meme stock phenomenon, non-fungible tokens (NFTs) and the increasingly convoluted machinations of the cryptocurrency world. And I think this idea of the value being shaped by perceptions has some utility. 

Meme stock phenomenon

Speculators buying GameStop are paying about as much attention to fundamentals as a slot machine patron in a Casino is to the odds. And it’s tempting to simply dismiss these as pockets of excessive risk appetite, consistent with all market cycles. That’s been my default response so far. But there’s something fundamentally different about this cycle. 

In a negative interest rate world, Central Banks have created an environment which favours asset prices over dividends or income flows – arguably supportive of value being created away from the factory and more in the mind.

You look back at the early career of Warren Buffett when he espoused this idea of cigar-butt investing in which he discarded everything about the potential for future growth. All of the emphasis was on tangible assets and buying at a discount to an assessment of value. Now we almost have the opposite, where we are discarding everything other than potential growth. 

Equity issuance by money losing firms

According to Bloomberg, during the past 12 months, almost 750 money-losing firms have sold shares in the secondary market, exceeding those that make profits by the biggest margin since at least 1982. A rush by companies to sell their shares you may consider to be ominous for the market. Where most of those sales come from firms that don’t make money, it raises concerns to another level.

Unarguably the relevance of the Buffett cigar-butt approach has long since passed. The question is, how far can its antithesis go?  Tying price back to value, or perception back to reality is more difficult in a digital world that is arguably less tangible.     

What’s missing in the canon of traditional valuation?

This sounds like I’m trying to make the case for greater fool investing; justifying buying at ever inflated prices so long as you can find someone to sell the asset to at a higher price.  I’m not. I’m a long time Buffett admirer and advocate of his investing principles. 

But I’m trying to understand what may be missing in the canon of the more traditional approach to market and company valuation that this cycle seems to have laid to waste. 

It’s always struck me as very agreeable to tie an investment decision to the price you are paying with the anchor in this process being the funding cost. Excluding any risk premium, that cost has been negative for years now. Add to this mix a growing proportion of intangible assets - brand, reputation, culture, or customer networks - in overall market valuation, and you can see how the traditional approach to investment appraisal has become unmoored. 

One of the great downsides to market conditions where a greater proportion of value is intangible or even in the eye of the beholder, is that it is a much harder environment in which to forecast. Try predicting the next YouTube sensation and you’ll get a sense of the complexity. 

I’m still on the side of sceptics when it comes to meme stocks, not to mention NFTs. I’m more open to being convinced about the efficacy of cryptocurrency. Just don’t press me on which one. 

Long held investing principles remain intact. But the job of the financial market soothsayer has never been harder.

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