The Storming of the Bastille: The Reddit Crowd targets the Hedge Funds!

I generally try to stay out of fights, especially when they become mud-wrestling contests, but the battle between the hedge funds and Reddit investors just too juicy to ignore. As you undoubtedly know, the last few days have been filled with news stories of how small investors, brought together on online forums, have not only pushed up the stock prices of the stocks that they have targeted (GameStop, AMC, BB etc.), but in the process, driven some of the hedge funds that have sold short on these companies to edge of oblivion. The story resonates because it has all of the elements of a David versus Goliath battle, and given the low esteem that many hold Wall Street in, it has led to sideline cheerleading. Of course, as with everything in life, this story has also acquired political undertones, as populists on all sides, have found a new cause. I don't have an axe to grind in this fight, since I don't own GameStop or care much about hedge funds, but I am interested in how this episode will affect overall markets and whether I need to change the ways in which I invest and trade.

Short Sales and Squeezes

I know that you want to get to the GameStop story quickly, but at the risk of boring or perhaps even insulting you, I want to lay the groundwork by talking about the mechanics of a short sale as well as how short sellers can sometimes get squeezed. When most of look at investing, we think of stocks that we believe (based upon research, instinct or innuendo) will go up in value and buying those stocks; in investing parlance, if you do this, you have a "long" position. For those of you tempted to put all of Wall Street into one basket, it is worth noting that the biggest segment of professional money management still remains the mutual fund business, and mutual funds are almost all restricted to long only positions. But what if you think a stock is too highly priced and is likely to go down? If you already own the stock, you can sell it, but if you don't have a position in the stock and want to monetize your pessimistic point of view, you can borrow shares in the stock and sell them, with an obligation to return the shares at a unspecified point in time in the future. This is a “short” sale, and if you are right and the stock price drops, you can buy the shares at the now "discounted" price, return them to the original owner and keep the difference as your profit.

Short sellers have never been popular in markets, and that dislike is widely spread, not just among small investors, but also among corporate CEOs, and many institutional investors. In fact, this dislike shows up not only in restrictions on short selling in some markets, but outright bans in others, especially during periods of turmoil. I don't believe that there is anything inherently immoral about being a pessimist on markets, and that short selling serves a purpose in well-functioning markets, as a counter balance to relentless and sometimes baseless optimism. In fact, mathematically, all that you do in a short sale, relative to a conventional investment, is reverse the sequence of your actions, selling first and buying back later.

It is true that short sellers face a problem that their long counterparts generally do not, and that is they have far less control over their time horizons. While you may be able to sell short on a very liquid, widely traded stock for a longer period, on most stocks, your short sale comes with a clock that is ticking from the moment you initiate your short sale. Consequently, short sellers often try to speed the process along, going public with their reasons for why the stock is destined to fall, and they sometimes step over the line, orchestrating concerted attempts to create panic selling. While short sellers wait for the correction, they face multiple threats, some coming from shifts in fundamentals (the company reporting better earnings than expected or getting a cash infusion) and some from investors with a contrary view on the stock, buying the stock and pushing the stock price up. Since short sellers have potentially unlimited losses, these stock price increases may force them to buy back shares in the market to cover their short position, in the process pushing prices up even more. In a short squeeze, this cycle speeds up to the point that short sellers have no choice but to exit the position.

Short squeezes have a long history on Wall Street. In 1862, Cornelius Vanderbilt squeezed out short sellers in Harlem Railroad, and used his power to gain full control of the New York railroad business. During the 20th century, short sales ebbed and flowed over the decades, but lest you fall into the trap of believing that this is a purely US phenomenon, the short sale with the largest dollar consequences was the one on Volkswagen in 2008, when Porsche bought enough shares in Volkswagen to squeeze short sellers in the stock, and briefly made Volkswagen the highest market cap company in the world. Until this decade, though, most short squeezes were initiated and carried through by large investors on the other side of short sellers, with enough resources to force capitulation. In the last ten years, the game has changed, for a number of reasons that I will talk about later in this post, but the company where this changed dynamic has played out most effectively has been Tesla. In the last decade, Tesla has been at the center of a tussle between two polarized groups, one that believes that the stock is a scam and worth nothing, and the other that is convinced that this is the next multi-trillion dollar company. Those divergent viewpoints have led to the former to sell short on the stock, making Tesla one of the most widely shorted stocks of all time, and the latter buying on dips. There have been at least three and perhaps as many as five short squeezes on Tesla, with the most recent one occurring at the start of 2020. With Tesla, individual investors who adore the company have been at the front lines in squeezing short sellers, but they have had help from institutional investors who are also either true believers in the company, or are too greedy not to jump on the bandwagon.

The Story (so far)

This story is still evolving, but the best way to see it is to pick one company, GameStop, and see how it became the center of a feeding frenzy. Note that much of what I say about GameStop could be said about AMC and BB, two other companies targeted in the most recent frenzy.

A Brief History

GameStop is a familiar presence in many malls in the United States, selling computer gaming equipment and games, and it built a business model around the growth of the gaming business. That business model ran into a wall a few years ago, as online retailing and gaming pulled its mostly young customers away, causing growth to stagnate and margins to drop, as you can see in this graph of the company’s operating history:

Leading into 2020, the company was already facing headwinds, with declining store count and revenues, and lower operating margins; the company reported net losses in 2018 and 2019.

The COVID Effect

In 2020, the company, like most other brick and mortar companies, faced an existential crisis. As the shutdown put their stores out of business, the debt and lease payments that are par for the course for any brick-and-mortar retailer threatened to push them into financial distress. The stock prices for the company reflected those fears, as you can see in this graph (showing prices from 2015 through the start of 2021):

Looking at the graph, you can see that if GameStop is a train wreck, it is one in slow motion, as stock prices have slid every year since 2015, with the added pain of rumored bankruptcy in 2019 and 2020. 

A Ripe Target and the Push Back

While mutual funds are often constrained to hold only long positions, hedge funds have the capacity to play both sides of the game, though some are more active on the short side than others. While short sellers target over priced firms, adding distress to the mix sweetens the pot, since drops in stock prices can put them into death spirals. The possibility of distress at GameStop loomed large enough that hedge funds entered the fray, as can be seen in the rising percentage of shares held by short sellers in 2020:

Note that short seller interest in GameStop first picked up in 2019, and then steadily built up in 2020. Even prior to the Reddit buy in, there were clearly buyers who felt strongly enough to to push back against the short sellers, since stock prices posted a healthy increase in the last few months of 2020. To show you how quickly this game has shifted, Andrew Left, one of the short sellers, put out a thesis on January 21, where he argued that GameStop was in terminal decline, and going to zero. While his intent may have been to counter what many believed was a short squeeze on the stock in the prior two days, it backfired by drawing attention to the squeeze and drawing in more buyers. That effect can be seen in the stock price movements and trading volume in the last few days:

This surge in stock prices was catastrophic for short sellers, many of whom closed out (or tried to close out) their short positions, in the process pushing up prices even more. Melvin Capital and Citron, two of the highest profile names on the short selling list, both claimed to have fully exited their positions in the last few days, albeit with huge losses.  On January 27 and 28, regulators and trading platforms acted to curb trading on GameStop, ostensibly to bring stability back to markets, but traders were convinced that the establishment was changing the rules of the game to keep them from winning. GameStop, which had traded briefly at over $500/share was trading at about $240 at the time this post was written.

A Value Play?

When you have a pure trading play, as GameStop has become over the last few weeks, value does not even come into play, but there are investors, who pre-date the Redditors, who took counter positions against the short sellers, because they believed that the value of the company was higher. At the risk of ridicule, I will value the company, assuming the most upbeat story that I can think of, at least at the moment:

Note that this valuation is an optimistic one, assuming that probability of failure remains low, and that GameStop makes it way back to find a market in a post-COVID world, while also improving its margins to online retail levels. If you believe this valuation, you would have been a strong buyer of GameStop for much of last year, since it traded well below my $47 estimate. After the spectacular price run up in the last two weeks, though, there is no valuation justification left. To see why, take a look at how much the value per share changes as you change your assumptions about revenues and operating margins, the two key drivers of value.

Even if GameStop is able to more than double its revenues over the next decade, which would require growth in revenues of 15% a year for the next five years, and improve its margins to 12.5%, a supreme reach for a company that has never earned double digit margins over its lifetime, the value per share is about half the current stock price. Put simply, there is no plausible story that can be told about GameStop that could justify paying a $100 price, let alone $300 or $500.

The Backstory

To put the GameStop trading frenzy in perspective, let's start with the recognition that markets are not magical mechanisms, but represent aggregations of human beings making investment judgments, some buying and some selling, for a variety of reasons, ranging from the absurd to the profound. It should therefore not come as a surprise that the forces playing out in other aspects of human behavior find their way into markets. In particular, there are three broad trends from the last decade at play here:

1. A loss of faith in experts (economic, scientific, financial, government): During the 20th century, advances in education, and increasing specialization created expert classes in almost every aspect of human activity, from science to government to finance/economics. For the most part, we assumed that their superior knowledge and experience equipped them to take the right actions, and with our limited access to information, we often were kept in the dark, when they were wrong. That pact has been shattered by a combination of arrogance on the part of experts and catastrophic policy failures, with the 2008 banking crisis acting as a wake up call. In the years since, we have seen this loss of faith play out in economics, politics and even health, with expert opinion being cast aside, ignored or ridiculed. 
2. An unquestioning worship of crowd wisdom, combined with an empowering of crowds: In conjunction, we have also seen the rise of big data and the elevation of "crowd" judgments over expert opinions, and it shows up in our life choices. We pick the restaurants we eat at, based on Yelp reviews, the movies we watch on Rotten Tomatoes and the items we buy on customer reviews. Social media has made it easier to get crowd input (online), and precipitate crowd actions.
3. A conversion of disagreements in every arena into the personal and the political: While we can continue to debate the reasons, it remains inarguable that public discourse has coarsened, with the almost every debate, no matter in what realm, becoming personal and political. I can attest to that from just my personal experiences, especially when I post on what I call "third rail" topics, specifically Tesla and Bitcoin, in the last few years. 

As I look at the GameStop episode play out, I see all three of these at play. One reason that the Redditors targeted GameStop is because they viewed hedge funds as part of the "expert" class, and consequently incapable of getting things right. They have used social media platforms to gather and reinforce each others' views, right or wrong, and then act in concert quickly and with extraordinary efficiency, to move stock prices.  Finally, even a casual perusal of the comments on the Reddit thread exposes how much of this is personal, with far more comments about how this would teach hedge funds and Wall Street a lesson than there were about GameStop the company.

The End Game

I am a realist and if you are one of those who bought GameStop or AMC in recent days, I know that there is only a small chance that you will be reading this post, since I am probably too old (my four children remind me of that every day), too establishment (I have been teaching investing and valuation for 40 years) and too expert to be worth listening to.  I accept that, though if you are familiar with my history, you should know that I have been harsh on how investing gets practiced in hedge funds, investment banks and even Omaha. The difference, I think, between our views is that many of you seem to believe that hedge funds (and other Wall Streeters) have been winning the investment sweepstakes, at your expense, and I believe that they are much too incompetent to do so. In my view, many hedge funds are run by people who bring little to the investment table, other than bluster, and charge their investors obscene amounts as fees, while delivering sub-standard results, and it is the fees that make hedge fund managers rich, not their performance. It is for that reason that I have spent my lifetime trying to disrupt the banking and money management business by giving away the data and the tools you need to do both for free, as well as pretty much everything I know (which is admittedly only a small subset) about investing in my classes. My sympathies lie with you, but I wonder what your end game is, and rather than pre-judge you, I will offer you the four choices: 

1. GameStop is a good investment: That may be a viable path, if you bought GameStop at $40 or $50, but not if you paid $200 or $300 a share. At those prices, I don’t see how you get value for your money, but that may reflect a failure of my imagination, and I encourage you to download my spreadsheet and make your own judgments.
2. GameStop remains a good trade: You may believe that given your numbers (as individual investors), you can sell the stock to someone else at a higher price, but to whom? You may get lucky and be able to exit before everyone else tries to, but the risk that you will be caught in a stampede is high, as everyone tries to rush the exit doors at the same time. In fact, the constant repetition of the mantra that you need to hold to meet a bigger cause (teach Wall Street a lesson) should give you pause, since it is buying time for others (who may be the ones lecturing you) to exit the stock. I hope that I am wrong, but I think that the most likely end game here is that AMC, GameStop and Blackberry will give back all of the gains that they have had from your intervention and return to pre-action prices sooner rather than later.
3. Teach hedge funds and Wall Street a lesson: I won't patronize you by telling you either that I understand your anger or that you should not be angry. That said, driving a few hedge funds out of business will do little to change the overall business, since other funds will fill the void. If this is your primary reason, though, just remember that the money you are investing in GameStop is more donation to a cause, than an investment. If you are investing tuition money, mortgage savings or your pension fund in GameStop and AMC, you are impoverishing yourself, trying to deliver a message that may or may not register. The biggest threat to hedge funds does not come from Reddit investor groups or regulators, but from a combination of obscene fee structures and mediocre performance. 
4. Play savior: It is possible that your end game was selfless, and that you were trying to save AMC and GameStop as companies, but if that was the case, how has any of what’s happened in the last two weeks help these companies? Their stock prices may have soared, but their financial positions are just as precarious as they were two weeks ago. If your response is that they can try to issue shares at the higher prices, I think of the odds of being able to do this successfully are low for two reasons. The first is that planning a new share issuance takes time, requiring SEC filings and approval. The second is that the very act of trying to issue new shares at the higher price may deflate that price. In a perverse way, you might have made it more difficult for GameStop and AMC to find a pathway to survive as parts of larger companies, by pushing up stock prices, and making them more expensive as targets.

If you are in this game, at least be clear with yourself on what your end game is and protect yourself, because no one else will. The crowds that stormed the Bastille for the French Revolution burned the prison and killed the governor, but once done, they turned on each other. Watch your enemies (and I know that you include regulators and trading platforms in here), but watch your friends even more closely!

Market Lessons

If you are not a hedge fund that sold short on the targeted stocks, or a trader who bought in on other side, are there any consequences for you, from this episode? I do think that we sometimes read too much into market events and episodes, but this short period has some lessons.

1. Flattening of the Investment World: Borrowing a term from Tom Friedman, I believe that the investment world has flattened over the last few decades, as access to data and powerful tools widens, and trading eases. It should come as no surprise then that portfolio managers and market gurus are discovering that they no longer are the arbiters of whether markets are cheap or expensive, and that their path of least resistance might come from following what individual investors do, rather than lead them. In a prior post, I pointed to this as one reason why risk capital stayed in the game in 2020, confounding many long-term market watchers, who expected it to flee. 
2. Emptiness of Investment Expertise: Professional money management has always sold its wares (mutual funds, hedge funds, investment advice) as the products of deep thinking and serious analysis, and as long as the processes stayed opaque and information was scanty, they were able to preserve the delusion. In the last few decades, as we have stripped away the layers, we have discovered how little there is under the surface. The hand wringing on the part of money managers about the momentum trading and absence of attention to fundamentals on the part of Redditors strikes me as hypocritical, since many of these money managers are themselves momentum players, whose idea of fundamentals is looking at trailing earnings. My prediction is that this episode and others like it will accelerate the shift from active to passive investing, especially on the part of investors who are paying hefty fees, and receiving little in return.
3. Value ≠ Price: I won’t bore you again with my distinction between value and price, but it stands me in good stead during periods like this one. During the last week, I have been asked many times how I plan to change the way I value companies, as a result of the GameStop story, and my answer is that I don’t. That is not because I am stuck in my ways, but because almost everything that is being talked about (the rising power of the individual investors, the ease of trading on apps like Robinhood, the power of social media investing forums to create crowds) are factors that drive price, not value. It does mean that increasing access to data and easing trading may have the perverse effect of causing price to vary more, relative to value, and for longer periods. My advice, if you are an investor who believes in fundamentals, is that you accept this as the new reality and not drive yourself in a frenzy because you cannot explain what other people are paying for Tesla, Airbnb or Zoom.

In the next few weeks, I predict that we will hear talk of regulatory changes intended to protect investors from their own excesses. If the regulators have their way, it will get more difficult to trade options and borrow money to buy shares, and I have mixed feelings about the efficacy of these restrictions. I understand the motivation for this talk, but I think that the best lessons that you learn about risk come from taking too much or the wrong risks, and then suffering the consequences.

YouTube Video

Spreadsheet

1. Valuation of GameStop (January 28, 2021)

Icahn exits, Buffett enters, Whither Apple? Value and Price Effects of Big Name Investing

In my last post, I looked at Apple, arguing, with a Monte Carlo simulation, that the stock was a good investment at the prevailing market price ($93 at the time of the analysis). I appreciate the many comments that I got on the analysis, some taking issue with the distributions that I used for profit margins and revenue growth and some taking me to task for ignoring the fact that big name investors were either entering and exiting the stock. Those who felt that my valuation was optimistic pointed out that Carl Icahn, a long time and very vocal investor in Apple, had decided to sell his stake in the company on April 28. Some who concurred with my value judgment on Apple pointed out that Berkshire Hathaway (and by extension, Warren Buffett or his proxies) had invested in the company on May 16.  Should Carl Icahn’s decision to sell Apple or Berkshire Hathaway’s choice to buy it change my assessments of value or views on its price? More generally, should the decisions by "big name" investors to buy or sell a specific company affect your investment judgments about that company? 

Price versus Value: The Set Up

To set up the discussion of whether, and if so how, the actions of other investors, especially those with big names and reputations to match, affect your investing choices, I will fall back on a device that I have used before, where I contrast the value and pricing processes.

Put simply, the value process is driven by a company's fundamentals (cash flows, growth and risk) or at least your perception of those fundamentals, whereas  the pricing process is driven by demand and supply, with mood, momentum and liquidity all playing big roles in determining price. In an earlier post,  I argued that it these processes that separate investors from traders, with investors focused on the drivers of value and traders on the pricing process, and that the skills and tools that you need to be a successful trader are different from those that you need to be a successful investor. To understand how and why the entry of a big name investor may alter your assessments of value and price, I would suggest categorizing that investor into one of four types.

1. An Insider, who is either part of management or has privileged access to management.
2. An Activist, who plans to change the way the firm is run or financed.
3. A Trader, whose skill lies in playing the pricing game, with the power to either reinforce or reverse price momentum
4. A Value Investor, who has valued the company and is willing to take a position based upon that value, on the expectation that the pricing gap will close.

Each type of big name investor has the potential to change how you view the dynamics of price and value, though the place where the change occurs will depend on the investor type.

The entry (or exit) of a big name insider or big name activist can alter your estimate of value for a company, by either changing your perceptions of cash flows, growth and risk or by having the potential to change the company's operating and financing characteristics. As a trader, the entry or exit of a big name trader may cause you to move from one side of the pricing game to the other, i.e., shift you from being a buyer to a seller. Finally, as a long term value investor who believes that a stock is mis-priced but has little or no power to cause the pricing gap to close, the entry of a big name value investor can provide a catalyst for the correction.

The Value Effect 

If you asked a value purist whether the actions of other investors affect his or her value, the answer will almost always be "of course not". After all, the essence of intrinsic value is that it is determined not by what others think about the company but the company's capacity to generate cash flows  over time. That said, there are two ways that the investment action (to buy or sell) of a big name investor can change your assessment of value. 

1. The first is if the big name investor has private information or is perceived as knowing more about the firm than you do. While that may walk awfully close to the insider trading line in the United States, it is entirely possible that the investor's information is diffuse enough to not be in violation of the law. In this case, it is entirely rational for you, as an investor, to reassess your cash flows and risk, based upon the insiders' actions. That is perhaps why we are so fascinated by insider trading, where the perception is that insider buying is value increasing and insider selling is value selling. In some emerging markets, where possessing proprietary information is neither illegal nor unusual, and the decision by an investor who is perceived as having this information (an insider, manager or family member) to buy (or sell) is an indicator that your value should be increased (decreased). 
2. The other scenario is where the big name investor is an activist who plans to push for changes in the way the company operates, how it is financed or how much and how it returns cash to investors. The potential effects of these changes can be most easily seen using a financial balance sheet:

To the extent that you believe that the company will have to respond to activist pressure, your assessment of value will change. An asset restructuring can alter he cash flows and risk characteristics of a business, changing your estimate of value, though the direction of the value change and its magnitude will depend on how you see these operating changes playing out in cash flows and growth.  Adding debt to your financing mix can add value to a firm (because of the tilt in the tax code towards debt) or destroy value (because it exposes companies to bankruptcy risk). If you are valuing a company, the entry of a big name activist investor in the ranks with a history of pushing for more debt could lead you to reassess your value estimate as well. Returning more cash to stockholders in special dividends or buybacks can change value either upwards (if the market is discounting the cash on the presumption that the company would waste the cash on bad investments/acquisitions) or downwards (if returning the cash will expose the firm to default risk or substantial financing costs in the future).

The Pricing Effect

In some cases, the big name investing in the stock is a trader, doing so on the expectation that momentum will either continue, sustaining the pricing trend, or that momentum will reverse, causing the trend to reverse as well. Since this trade is not motivated by either new information or the desire to change how the company is run, there is no value effect, but there can be a price effect for two reasons. 

1. The volume effect: If the big name trader has enough money to back his or her trade, there will be a liquidity effect, where a buy will push the price up higher and a sell will push it lower. 
2. The bandwagon effect: To the extent that there are some in the market who perceive the big name trader as better at perceiving momentum swings than the rest of us, they will follow the investor in buying or selling the stock. 

In contrast to a value effect, which is long term and sustained, the pricing effect will have a shorter half life. To the extent that the big name trader's time horizon may be even shorter, he or she can still make money from the bandwagon effect. To get a measure of the pricing effect of a big name trade, you have to look at both the resources commanded by the trader as well as the liquidity/trading volume in the stock. A trader with billions under his control investing in a lightly traded and lightly followed stock will have a much bigger pricing effect than in a very liquid, large market capitalization company. 

The Catalyst Effect

It is an undeniable and frustrating truth about value investing that for most of us, it is not just enough to be right in your assessment of value but you have to get the market to correct its mistakes to make money on your investments. If you are a small investor, there is little that you can do to close the pricing gap because you have neither the money or the megaphone to close the gap. A big name value investor, though, may be more successful for two reasons: he or she can take a larger position in the stock and as with the big name trader, create a bandwagon effect where other value investors will follow into the stock.  Again, the magnitude of the catalyst effect will vary across both investors and companies. The extent of the impact on the pricing gap will depend in large part on the history of success that the big name investor brings into the investment, with sustained success in the past going with a larger impact. 

Apple, Icahn and Buffett

It has taken me a while to get to the point of this post, which was ostensibly about Apple and how Icahn’s exit and Buffett’s entry into the stock affect my thinking. At first sight, this graph shows how the market reacted to their actions:

While it does look like Icahn's sale had a negative effect (albeit mild) and Berkshire's buy had a positive effect (almost as mild), I plan to use the framework of the last section to assess each of these investors and gauge how it should affect my thinking about the stock.

Icahn, the Activist Trader

Through much of his tenure, Carl Icahn has been labeled an activist investor but I will take issue with at least a portion of that label. It is true that Icahn is an activist, though he is much more active on the financing/dividend dimension (pushing companies to borrow money and return cash) than on the operating dimension. I do think that Icahn is more of a trader than an activist, more focused on momentum and pricing than on value and this is illustrated by the tools that brings to the assessment. When Icahn was asked why he invested in Lyft in 2015, his response was that it looked cheap relative to Uber, a classic pricing argument. With Apple, in his bullish days, Icahn argued that it was cheap, but consider how he justified his contention in May 2015, that Apple, then trading at $100, should really be trading at $240. In effect, he forecast out earnings per share in 2016 to be $12, applied a PE ratio of 18 and added the cash balance of $24.44/share. Not only is this definitely not an intrinsic valuation, it is at best "casual pricing", i.e., the type of pricing you would do on the back of an envelope after you have had a little too much to drink.

Before you point out to me that Icahn is worth billions and I am not, let me hasten to add that there is nothing ignoble about trading and that Icahn has been an incredibly successful trader over the last few decades, testimonial to his targeting and trading skills. It does color how I viewed Icahn’s investment in Apple in January 2014, his push at Apple for more dividends and more debt during his days as a Apple investor and his decision to sell his holdings on April 2016. I was already an investor in Apple in January 2014, when Icahn bought his shares, and while I did not view his decision to buy the shares as vindication of my valuation, I welcomed him to the shareholder ranks both because Apple was badly in need of a momentum shift and Icahn was playing both an activist and a catalyst role. I am glad that he put pressure on Apple to get over its unwillingness to borrow money and to return more cash in dividends and buybacks. His decision to depart does tells me two things. First, Icahn has recognized the limitations of financing and dividend policy changes in driving Apple’s value and is moving on to companies where the payoff is greater from financial reengineering. Second, it is possible that Icahn’s momentum detector is telling him that while Apple’s stock price may not be going lower, it has little room to go higher either, at least in the short term, and given his trading track record, I would take that signal seriously,

Buffett Buys In?

The decision by Berkshire Hathaway to invest in Apple about three weeks after Icahn’s departure mollified some worried Apple investors, since there is no more desirable endorsement in all of value investment than Warren Buffett’s buy order. I am not privy to the inner workings in Omaha, but I have a feeling that this decision was made more by Todd Combs and Ted Wechsler, the co-heads that Buffett hired as his successors, than by Buffett, but let’s assume that they are following the Buffett playbook. What does that tell you about Apple stock? The good news is that the greatest value investor of this generation now considers Apple to be a value stock. The bad news is that this investor's biggest investment in a technology company has been in IBM, a company that delivers solid dividends and cash flows but has been liquidating itself gradually over the last ten years. If my value judgment on Apple had required substantial growth for value to be delivered, Buffett’s investment could very well have adversely affected my view on the company. In this case, though, I agree with his assessment that Apple is a mature company, with enough cash flows to cover dividends for a generation. 

The Apple End Game

In early May, when I analyzed Apple, I knew that Carl Icahn had already closed out his position and it had no impact on my value estimate or investment judgment. Icahn’s decision to sell was an indication to me that the price might not recover quickly and that momentum could work against me in the near term, but I was okay with that, since my time horizon was not constrained. Buffett’s decision (if it was his) to jump in, a couple of weeks later, may be an indication that the best days of Apple are behind it, but I had already made the same judgment in my valuation. If there is a silver lining, it is that Buffett's followers, with their large numbers and unquestioning, will imitate him and perhaps get the price gap to close. 

The Dark Side of Big Name Investing
While I am open to the possibility that the entry of a big name into a company has the potential to change the way I think about the company and perhaps my investment decisions, there are dangers embedded in doing so.

1. Confirmation bias: It is a well-established fact that investors look for evidence that confirms decisions that they have already made and ignore evidence that contradicts it and big name investors feed into this bias. Thus, if you have bought a stock, you are far more likely to focus in on those big name investors who agree with you (and are either bullish on the stock or buy it) and screen out big name investors who do no.
2. Mixed Motives: It is entirely possible that you (as an investor) may be misreading or misunderstanding the motives that caused the big name trade in the first place. In particular, the insider, who you assumed was trading because he or she had private information, may be selling the stock for tax or liquidity reasons. The activist, who you assumed was pushing for real changes in the company, may be more interested in collecting a payoff from the company to leave it alone. The trader, who you assumed had skills playing the momentum game, may himself be following the crowd rather than assessing momentum shifts. Finally, the value investor, who you assumed had valued the company and was pushing for the price/value gap to close, may be more trader than investor, quick to give up, if the stock moves in the wrong direction.

There are some investors, including many institutional investors, whose entire investment strategy seems to be built around watching what big name investors do and imitating them. While imitation may be the best form of flattery, it is inauthentic and a poor basis for an investment philosophy, no matter who the big name investor that you are imitating is and how successful he or she has been. We are too quick to attribute investment success to skill and wisdom and that much of what passes for "smart" money is really "lucky" money. My advice is that if you have an investment thesis that leads you to buy the stock, do so and stop worrying about what the talking heads on CNBC or Bloomberg tell you about it. If you have so little faith in your reasoning that you doubt it and are ready to abandon it the moment it is contested by a big name, you should consider investing in index funds instead.

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