The impossible quest for fair markets: Pokemon cards, HFT and Life lessons

In my last post, I looked at the Insider Trading 2.0 doctrine advanced by Eric Schneiderman, the Attorney General for New York, and argued that is was overly broad and likely to create more harm than good for small traders/investors, the very group that he wants to help. Mr. Schneiderman is drawing on what we all accept is a laudable goal, which is the search for fairness. It is, however, an impossible mission and I will use a personal story to bring it home.

The parental dilemma
My children are all grown up now, but when one of my sons was five years old, the Pokemon trading frenzy was in full force, and as a neighborhood with more than a dozen young children, we were exposed. For much of the summer, the trading volume in Pokemon cards was high, as children, most of whom could barely read, traded Pokemon cards with each other, with emotion, impulse and that morning's Pokemon episode on TV driving trades. Sometime in late June, my son came home crestfallen, after a day of trading disappointments, full of complaints about market unfairness. A six-year old (who I will call HFT to disguise his identity) had entered the Pokemon market with two powerful advantages: he could read relatively well and he had a Pokemon trading card book, which he had used to "exploit" the rest of the market.

Choices and Consequences
If Mr. Schneiderman had lived in my neighborhood, he would undoubtedly have come with regulations on trading that would have protected the weaker traders, either by requiring passing a reading test to trade in the market (which would have left the six year old as the only trader in the market, and killed it) or failing that reading test as a prerequisite, which would have led to cheating and/or a black market in Pokemon cards. I am afraid that I did not have the legal authority over my neighborhood to concoct a version of Pokemon Cards 2.0, and my son and I, after some discussion, came up with four options:

1. If you cannot beat them, join them: I suggested that he spend the rest of the summer, learning how to read better and promised that I would buy him the Pokemon trading book as a reward, an option he quickly and rightfully rejected as a summer-vacation killer. 
2. Reorient your trading: I noted that he could be selective about his trading partners, avoiding the well-read six year old at all cost and looking for other children in the neighborhood who could read less than he (my son) as trading partners. I offered this laws-of-the-jungle choice reluctantly, and I was relieved when my son, after thinking about it for a few minutes, decided that he could not take advantage of babes in the market (literally speaking). 
3. Become an intermediary: He could quit trading and become an intermediary in the market, charging a commission (Nickels, candy etc.) for bring buyers and sellers together, but after giving this some consideration, my son demurred, noting that his role would then be finding suckers for HFT to take advantage of. 
4. Leave the market: My son came up with the fourth choice himself, which was to recognize the reality that he could not win in this market and that the most prudent decision to take was to exit the market, which he did by liquidating his card inventory the next day. 

There is a happy ending to this story. That summer, HFT cornered the market and acquired the best Pokemon card collection in town, at bargain prices. By the next summer, though, his advantage dissipated, because there were at least three other kids in the neighborhood who could read, with their own Pokemon guidebooks. The game became more of a "loser's game", as HFT found himself trading almost as frequently with traders who were as informed as he was, or better. He also made the mistake that many successful traders make of ignoring the fundamentals, which with collectibles is simple: the price is inversely related to the supply and if the supply is unchecked the price will go towards zero. I must admit that I was secretly happy when I saw HFT's entire card collection up for grabs for a couple of dollars at a garage sale a few years later.

Trading in an HFT World
There is a larger debate that is worth having about high frequency trading that has nothing to do with insider trading. It has changed the trading game, putting small traders at a disadvantage. My father-in-law was a day trader in the 1970s, a time when information was transmitted in phone calls with brokers and trades were on the floor of the exchange. Information reached markets in a leisurely fashion and he was able to make his share of the profits. He was already a dinosaur by the 1990, when a new generation of traders used computers to both access information and trade on it, as the reaction time went from hours to minutes. Now those traders are being threatened by more powerful computers, as reaction times go from minutes to milliseconds. Like my son, I think that if you are a trader, you have four choices.

1. Invest in technology: You can try to compete with the HFT traders, paying for information and the latest trading technology, setting into process a game of mutually assured profit destruction. For most smaller traders, the investment is too steep to even consider this option.
2. Change your trading game: You can adapt your trading strategies to increase the likelihood that you are trading against those who are less informed (or more emotional) than you are and decrease the chances that you are trading against those who have an advantage over you. In particular, you can shift your trading from the periods when information is released (which is the moment when HFT has its maximum advantage) to the aftermath of the announcements. There is often as much money to be made in the price drifts after news releases as in the immediate reactions, and computerized trading has little or no advantage at this stage of the pricing game.
3. Become intermediaries who supply liquidity rather than trade on information, and it is a fact that even within the HFT community, there are some who have chosen this route, as the business becomes more competitive and less profitable.
4. Become an investor: You can stop playing the pricing game, i.e., being a trader, and play the value game, I.e., become an investor. As an investor, you are unaffected by computerized or high frequency trading, and at the margin, may even be helped by it. HFT trading takes the worst aspects of trading, following the crowd and the neglect of fundamentals, and magnifies them, driving price away from value in both directions. Like the neighborhood kid collecting Pokemon cards discovered years ago, fundamentals matter, and these big traders will face their day of reckoning, sooner than you think.

Impactful information is not always insider and insider Information is not always impactful!

One of the perils of living in New York is that it is home to two of the highest profile law enforcement officers in the United States, the US attorney for the Southern District of New York (the Justice Department’s lead person in the city) and the New York State Attorney General. Both positions attract smart lawyers, who are politically ambitious, and not surprisingly, they use these positions to maximize their media exposure. While the current position holders, Preet Bharara (as US attorney) and Eric Schneiderman (as NY AG) are either Democrats or appointed by Democrats, my rant is a non-partisan one, since Rudy Guiliani and Chris Christie launched their political careers from the US attorney perches (Christie used the Newark post).

Insider Trading 2.0

While Mr. Bharara has been busy going after hedge fund managers for crossing the insider trading line, it is Mr. Schneiderman who caught my attention last week with two highly publicized actions. He first announced an agreement with 18 investment banks, including JP Morgan and Goldman Sachs, that their equity research analysts would no longer participate in surveys that allowed some of their preferred clients to get advance looks at analyst sentiment changes. A few days later he announced a crackdown on high frequency trading and in particular, the practice of paying data providers to get information milliseconds before the rest of the market. He then wrapped up both actions in a neat little package and came up with a doctrine that he termed Insider Trading 2.0, with his justifications for why it was merited. While Mr. Schneiderman's motives may be noble (or at least they sound good), I don't think that he has thought through either the principles behind this new doctrine or the potential consequences. 

Insider Trading: The evolution of the concept

The US has the most stringent rules and regulations on insider trading and it is worth looking at how the law has evolved since its beginning. The first restrictions on insider trading were included in the Securities Exchange Act (Section 16(b)) of 1934 and were a reaction to the market crash of 1929 and the perception that company insiders had contributed to the market devastation by holding back information from investors and trading for personal profit. The original laws were directed at corporate insiders defined to include managers, directors, employees and large stockholders (owning more than 10% of the shares) and were designed to prevent them from trading on "material, non-public" information ahead of the rest of the market. A side effect of that law was the requirement that insiders, when trading legally on their company stock had to report such trading to the Securities Exchange Commission (SEC) in a filing (Form 4).

In the years, through a series of changes primarily from court interpretations of the law, the law has broadened to include a much larger group of investors.

Mr. Bharara's big wins against hedge funds have come from within the conventional confines of the insider trading law. Thus, in the case against Raj Rajratnam, the government argued and was able to prove that he was the recipient of inside information passed on by Rajat Gupta, then a director at both Goldman Sachs and Proctor and Gamble. In the more recent legal tangle with Mathew Martoma, a trader at Steve Cohen's SAC Capital, the core of the case was that he "seduced" and "corrupted" two doctors to provide him with confidential information about the results of clinical trials, which he then proceeded to use to trade in Elan and Wyeth, two pharmaceutical companies.

I am not a lawyer and the intricacies of some of the legal wrangling in these cases go over my head, but the overall tenor seems to be clear. While the initial focus of the law was on the individuals doing the trading (and whether they were insiders), it has shifted to the information being traded upon (and whether it is material and non-public). In effect, the insider trading laws, as structured now in the US and enforced by the SEC, are more laws that restrict trading ahead of impactful information than insider information.

Impactful information

Rather than use "material information", a legal term, I will start with a broader term that I will title "impactful" information, i.e., information that can be expected to impact the stock price. To make an assessment of whether this information can be legally traded on or should be classified as insider trading, we need to first categorize this information. As I see it, a company's stock price can be impacted by six types of information which I will classify into three sub-groups: fundamental, technical/trading and processed information.

a. Fundamental information

From an intrinsic value standpoint, the value of a company is altered by any information that can affect its cash flows, expected growth and risk, and that covers a lot of potential news. Sub-dividing fundamental information, the information can be about the company, it can be about the entire sector or it can be macro or market-wide information. Within each sub-group, there can be different sources of data.

Company-specific	1. Company: The most obvious source of information is the company itself, with earnings reports being the most frequently used vehicle for delivery of that information. In addition, companies sometimes make public announcements about investments (new projects, JVs and acquisitions) and dividend policy (dividend changes, stock buybacks etc.) 2. Outsiders: Some company-specific information is unearthed by investors and analysts in the course of doing research on the company, without accessing either company insiders or proprietary corporate data.
Sector-wide	1. Other companies in the sector: Earnings and investment announcements by other companies in the sector can be used to reassess investor expectations of market potential and profitability. Thus, the announcement by one auto company of higher-than-expected earnings can lead investors to push up expected earnings (and prices) at other auto companies. 2. Sector research: There are sector experts and consultants whose job it is to collect information about the overall sector and analyze it, with the intent of assessing sector trends and prospects.
Macro economic	1. Government: The biggest source of macroeconomic data (interest rates, inflation, economic growth) is the government through its many institutions. 2. Private entities: There are private entities that also generate macroeconomic data that markets react to. In the US, for instance ADP (a publicly traded company) produces a monthly national employment report and the Conference Board reports a composite index of leading economic indicators.

b. Trading information
In an efficient market, the only news that affects prices is fundamental, but in the markets that we live in, it is an undeniable truth that there is other information that affects prices. Putting my trading hat on,  information on trading volume, trends in trading, the identity of the traders and order flow can all affect prices.

Momentum (Trading volume/details)

1. Stock exchanges: The trading exchanges are the primary suppliers of data on trading volume and order flow (limit order). In addition, they also have data on short sales and bid ask spreads that may affect prices. 2. Private brokers/dealers: There are some private brokers and dealers who keep track of subsets of trading data. In some cases, they trade on this information and in others, they offer them to others (for a price).

Mood/Sentiment

1. Private entities: Many charting services collect data on investor sentiment on companies (bullish/bearish), primarily from surveys and provide this to subscribers. 2. Option exchanges: There are sentiment measures based on option prices and volume, especially by relating call option to put option values. The data is held by the option exchanges.

c. Processed information
In the final grouping, I would include processed information, i.e., analyst/investor reports and statistics based upon the processing of raw information from any of the sources listed above. Again, while this should have little or no impact on stock prices in an efficient market, these reports sometimes do affect stock prices.  For instance, sell side equity research analysts use an aggregation of all of the data listed above, in conjunction with their own views, to generate earnings estimates and recommendations (buy/sell/hold) on the companies they track. That information is often picked up by the press and made public, affecting stock prices.

The trade off
Breaking down impactful information into its component parts provides us with a framework for assessing insider trading laws and restrictions. In fact, there are some who adhere to the ends of the spectrum. A subset of free-market economists, led by Milton Friedman, has argued that investors should be allowed to trade on all types of impactful information and that there should be no insider trading laws. This case is best made in Henry Manne's numerous writings on the topic, including his book on insider trading. At the other end of the spectrum are those who believe that all impactful information is essentially insider information and trading on it should be restricted or banned.

To provide a template for assessing the different views of insider trading, I propose five guiding principles (some of which you may view as hopelessly utopian) that should guide our choices:

Guiding Principle 1: Information revealed by companies about their prospects should be unbiased, complete and be provided to markets in a timely fashion. 

Guiding Principle 2: There should exist a strong external information market (outside investors and analysts), investing resources to collect additional information and process it, with the intent of supplementing, complimenting and challenging corporate news releases.

Guiding Principle 3: The market reaction to the information should be appropriate (reflecting what that information reveals about the future prospects of the company) and immediate (with the price change, if any, happening instantaneously).

Guiding Principle 4: At any point in time, the market price should reflect all of the information, private or public, about a company.

Guiding Principle 5: Investors should perceive the information/pricing/market processes as fair. If investors perceive the trading game to be fixed in favor of some investors over other, they will withdraw from the market.

Using these principles, you can see why the limiting arguments are both problematic.

• The Manne/Friedman argument is built on the presumption of an efficient market and with the implicit assumption that guiding principle 4 (that the price reflect all available information) is the dominant one. However, it has its costs. Company insiders may hold back information so that they can trade on it (undercutting proposition 1), there is no incentive to develop a strong external information market (since insiders capture the rents) and investors may stop participating in the market if they perceive the game to be fixed. Over time, there will both less information and liquidity in this market.
• Classifying all impactful information as insider information, and banning trading on it, may improve investor perceptions of a fair market, advancing proposition 5, there be no incentive for outsiders to invest resources in collecting new information. Even if they do, there will be a black market for illegal (but impactful) information, which in turn will also undercut market efficiency both in terms of having the information being reflected in the market price and the speed with which it is reflected. That will also allow "illegal" insiders to capture more rent from their information.

A good insider trading law walks the fine line between fair and free markets and that has to come from a sensible break down of impactful information into the clearly illegal (insider information), the gray middle (where you have to look at the facts of the case to make the judgment) to the legal (impactful information).  As I see it, here is the breakdown:

Clearly Insider (should be regulated)	Gray area	Not insider (should be left to market forces)
1. Company news releases, including earnings reports and investment announcements. 2. Macroeconomic data from government and quasi-government entities.	1. Exchange data on trading volume, short sales and order flow. 2. Premium news, where news services provide preferred customers with information earlier than others.	1. Analyst earnings revisions and recommendations. 2. Investment newsletters 3. Survey-based data/indicators 4. Sector research/reports 5. Privately generated macroeconomic indicators

I think that insider trading rules should clearly apply to company-generated information and that governments should not play favorites, with macroeconomic data. I also believe that anyone (analysts, investment advisors, data services) who expends time and resources to collect their own data or do their own research should be free to reap the benefits of that data, either by trading on it themselves or selling it to others, to trade on. I have mixed feelings about exchanges selling privileged access to trading data (volume, order flow, short sales). While exchanges, at least in the US, are private entities, the trading data is a by-product of their primary business, which is to facilitate market trading. Offering preferential access to this data to their best or biggest traders strikes me as not only unfair but also not merited, since there was no investment made in collecting this data. In the same vein, news services that offer premium data feeds (for a price) to preferred customers are trying to exploit information that they had no role in gathering or processing and should be held accountable. In either case, I don't it is insider trading laws that they are guilty of breaking, but they are violating their fiduciary responsibilities (to traders, on the part of exchanges, and to the data collecting entities and  customers, for news service).

Impactful Information 1.0: The Analyst Case

To see why Schneiderman’s attempts to constrain equity research analysts really neither fits the definition of insider trading nor is merited, let’s look at the business of sell side equity research. Investment banks hire and pay equity research analysts who are given subsets of stocks (sectors and subsectors) to follow and analyze. Analysts have to estimate the earnings that these companies will be reporting in the near term and make judgments on their relative pricing (not valuation). In making these judgments, they are already barred from getting "material, non-public" information from the companies that they analyze, under both insider trading laws and SEC rules. (See Regulation FD) While you may be cynical about analysts actually following these rules, recognize that if they break these rules, you don’t need Insider Trading 2.0 to crack down on them. Insider Trading 1.0 will do. 

Analysts expend resources collecting data, processing it and converting it with varying degrees of skill into earnings estimates and stock recommendations. If their work has any merit, these estimates and recommendations, when made, should have an effect on stock prices (thus making it impactful information). It is at this stage that they outrage Mr. Schneiderman by making these estimates and recommendations available only to preferred clients, i.e., the clients who can be expected to deliver trading commissions to the investment bank. The NY attorney general seems to view analysts as public service providers, whose job it is to collect and process information for the market. It is not. The investment banks that hire them and pay for their research are not charitable institutions and are entitled to be selective about who gets to see the information first. In fact, if analyst revisions/recommendations are insider information, because they have price impact and thus cannot be offered to clients, where exactly do you draw the line on active investing and trading? If my skill is valuing companies and it is perceived to be good enough that my recommendations affect stock prices, am I barred from starting a paid newsletter? After all, my information is impactful and my clients will therefore be getting that information ahead of the market.

Impactful Information 1.0: The High Frequency Trading (HFT) Case

High frequency trading has become a catch all for high volume, computer-based trading. Stories such as these feed into the presumption that HFT is an immensely profitable enterprise, where the purveyors make huge profits by trading ahead of the rest of us. In his broadside against HFT, Mr. Schneiderman seems a little confused about what aspect of high frequency trading he finds more unfair, the fact that computers can trade faster than rest of us or that the HFT systems get information (and pay to get it) milliseconds ahead of the rest of us.

While I do have some sympathy for Schneiderman on the advance information being procured by HFT traders, to make a judgment on whether Insider Trading 2.0 is, in fact, merited, I would like to know what information is being acquired, and from whom. If the data is coming from a government agency (the Fed, Labor Department), I agree that information should be made available to all investors at the same time (though our legislators seem to have no qualms about trading on that information ahead of time). If it is a private entity, I find it hard to believe that insider trading laws actually apply. For instance, one of the examples provided by Schneiderman was of Reuters letting HFT clients buy Consumer Confidence survey (conducted by the University of Michigan) numbers a few milliseconds ahead of the rest of the market. Without entering the debate about whether this information has a market impact, it would seem to me that the problem here is that Reuters is not sharing that revenue with the University of Michigan. If the University of Michigan had chosen to offer this advance peek data for a price to customers willing to pay the price, how can that be considered insider trading?

The Greater Good?

Elliot Spitzer, in his high profile assault on sell-side equity research, a decade ago, and Eric Schneiderman in recent days have framed their actions as being in the interests of fair markets and protective of small investors. You can put me in the skeptical camp because the only group that does not seem to come out ahead from these actions is small investors. In spite of all of the ink that was spilt and the legal costs that were created by Spitzer’s crackdown on conflicted equity research, I don’t believe that sell side equity research is any less conflicted than it was (though the bias is hidden deeper and is more subtle) or of higher quality. After Schneiderman’s forays into Insider Trading 2.0, I remain convinced that small investors will have gained nothing from his crusade and will perhaps have lost access to information that used to be available. 

If it is a strategic growth investment in China, the numbers don't matter! Or do they?

If I were asked to characterize my investment philosophy, I would describe myself an investor who believes in value, but I would be lying if I told you that it has always come easily or naturally. My faith in value is tested constantly, not only by the recognition that there is far more that I don't know about value than I do, but also by the market, which seems to have an uncanny ability to sense my doubts and find ways to probe them.

The Market Test

To see if we share some of the same weaknesses, let's try an experiment. Assume that you value a stock at $20 and it is trading at $30. What would you do? If you are a value-based investor, the answer is easy, right? Don't buy the stock, or perhaps, sell it short! Now let's say it is three months later. You value the same stock again at $20 but it is now trading at $50. What would you do now? Rationally, the choice is simple, but psychologically, your decision just got more difficult for two reasons. The first stems from second guessing. Even if you believe that markets are not always rational, you worry that the market knows something that you don't. The second is envy. Watching other people make money, even if their methods are haphazard and their reasoning suspect, is difficult. You are being tested as an investor, and there are three paths that you can take. 

1. Keep the faith that your estimate of value is correct, that the market is wrong and that the market will correct its mistakes within your time horizon. That may be what every value investing bible suggests, but your righteousness comes with no guarantees of profits.
2. Abandon your belief in value and play the pricing game openly, either because your faith was never strong in the first place or because you are being judged (by your bosses, clients and peers) on your success as a trader, not an investor. 
3. Preserve the value illusion and look for "intrinsic" ways to justify the price, using one of at least three methods. The first is to tweak your value metrics, until you get the answer you want. Thus, if the stock looks expensive, based on PE ratios, you try EV/EBITDA multiples and if it still looks expensive, you move on to revenue multiples. As I argued in my post on the pricing of social media companies, you will eventually find a metric that will make your stock look cheap. The second is to claim to do a discounted cash flow valuation, paying no heed to internal consistency or valuation first principles, making it a DCF more in name than in spirit. The third is to use buzzwords, with sufficient power to explain away the difference between the price and the value.

If you choose the first path, I respect you for your principles. If you pick the second one, I understand your pragmatism. If you pick the third path, I think that you are on dangerous ground, as you wander the netherworld between trading and investing. Unfortunately, though, it seems to be the path most often taken and in this post, I would like to shine a spotlight on the buzzwords that are most frequently used by investors to distract and delude themselves and others.

The deadliest buzzwords

As someone who teaches at a business school, I am aware of both the ubiquity of buzzwords and their power in decision making. The most powerful buzzwords can still discussion, stifle dissent and overwhelm common sense and they share three characteristics. The first is that at their core, they are built around undeniable truths, even though those truths might get stretched in practice. The second is that they come with highbrow backing from academics and/or well-known practitioners, skilled at packaging and presenting these concepts to broad audiences. (An academic paper is nice, a book is better and an appearance on national TV show cements the deal). The third is that they tie into the world views of many investors and thus provide an intellectual rationale for anecdotal evidence and story telling. So, with no further ado, here are my five deadliest buzzwords, ranked from least to most potent (based upon my subjective judgment). I would hasten to add that I have been guilty of using some of these buzzwords myself and promise to be more careful in the future in both when and how I use them.

5. Optionality

What it really means: Success in a particular product or market may give a company the option to enter a different market (product-wise or geographically). Thus, Apple's success with the iPod allowed it to enter the music retailing market (with iTunes) and led eventually to the iPhone and the iPad.  From a valuation perspective, these possibilities could not have been foreseen (explicitly) in 1999, but the optionality could have been incorporated into the value.

In Buzzword form: You use the existence of a large market as a rationale for giving a company an option premium, often subjectively determined to be whatever you need it to be to justify buying the stock. In the late 1990s, some analysts used the potential of a large e-commerce market as justification for attaching option premiums to dot-com company valuations, just as many analysts are using the online advertising market as a reason for attaching option premiums to social media companies. 

The key test: Exclusivity. In its generic form, a call (put) option gives its holder the right to buy (sell) an asset. In the same vein, any optionality argument has to be built around exclusivity, where the company in question has the exclusive or close-to-exclusive right to expand into new markets. This exclusivity can come from owning a proprietary technology or possessing an exclusive license to operate in a market. The e-commerce companies of the late 1990s had no such exclusivity, and while the social media companies of today use their large user bases to stake out exclusivity, it is on shaky ground, since these users are fickle and quick to move to the "next big thing". With Apple, the exclusivity derived from the company's control of the operating system, making it very difficult for competitors to enter their very profitable ecosystem.

If you really mean it: If you are going to use an optionality argument, you have to be comfortable with both option pricing fundamentals and models. However, option valuation is not an alternative to traditional valuation, but an addendum. Thus, to value the optionality in a company, you have to do a discounted cash flow valuation first, make judgments on the size and uncertainty in potential markets next and then value the option. 

Links (perhaps helpful, perhaps not): (1) My paper on real options (2) A spreadsheet to value the option to expand.

4. Growth potential

What is really means: There is a large potential market for the firm's goods and services, which will allow the company to to scale up revenues and profits over time, without running into market capacity constraints. This argument has resonance when valuing small companies that operate in large markets, since high growth can be accommodated with ease. In my valuation of Tesla in September 2013, it was the magnitude of the automobile market that allowed me to make generous assumptions about revenue growth in the future.

In Buzzword form: You argue that a company has high value because it has growth potential, but you refuse  to be specific about the market that your company is operating in, how big the market is today and how much of that market your company will capture over time. (This is my bone of contention with analysts who use the online advertising market to justify high growth in social media companies, without clarifying their assumptions about the overall market.)

The key test: Excess returns. I may be beating a dead horse here, but growth, by itself, has no value. To create value, you need to earn excess returns while growing, and to earn those excess returns, you need barriers to entry and competition. Thus, if you are going to make an argument for growth potential, you have to twin that argument with one that explains what the company's competitive advantages will be that will allow it to create value from that growth.

If you really mean it: To value growth potential, you have to do the grunt work of defining the market, determining your company's competive advantages and forecasting how much you will have to reinvest to deliver that growth.

Links (perhaps helpful, perhaps not): (1) A spreadsheet to value growth

3. Strategic considerations

What it really means: Taking the action (investment, acquisition) is critical to the company's long term growth and profitability, though the short term effects may be negative.

In Buzzword form: You use strategic as prefix for any action where the numbers don't add up but you want to take anyway. Thus, a strategic acquisition is one where you pay too much for a sought-after target company, a strategic investment is one where you know you will never make money but is indispensable (at least to you) and in its most cringe-inducing form, you are a strategic buyer, i.e., one who will pay any price to buy something. 

The key test: Show me the money. You cannot pay dividends with strategic victories or nice sounding stories. All decisions, no matter how strategic and long term they might be, are ultimately financial decisions. Consequently, if you make the strategic argument, the onus is on you to then convert the qualitative benefits into earnings and cash flows. If you cannot show me the money, I am afraid that there is nothing strategic about this decision, other that the prefix.

If you really mean it: Start converting stories to numbers, dreams into plans and deal makers into managers. No matter how much uncertainty you face or how far in the future the benefits may lie, you need to put your best estimates down on paper, before you take action. Not only will that put some discipline into the process but it will also become the basis for organizing and planning to deliver those benefits and holding someone (perhaps you, since you pushed for it so hard) accountable.

Links (perhaps helpful, perhaps not): (1) My paper on valuing synergy (2) A spreadsheet to value synergy.

2. Disruptive

What it really means: A new entrant in an existing business uses a new or unorthodox business model to lower the costs of production (Southwest) or the delivery/distribution system (Amazon) or even the product/service (Apple). In the process of doing so, the disruptor finds way to be profitable at the expense of the status quo.

In buzzword form: You view any new entrant in a business as a disruptor, even if that entrant brings little of value to the process, no cost savings innovations or no game changing products, and is unlikely to change the way the business is run.

The key test: Status Quo. While disruption takes many forms and has happened in different markets, the common feature that allows it to succeed is dissatisfaction with the status quo, either on the consumer side (because consumers are not getting the products and services they want or are getting them at prices that they believe are too high) or on the producer side (because producers are unable to generate the economic profits they need to make to stay in business).

If you really mean it: You have to complete the story of disruption by fleshing out the details. In particular, you have to map out a pathway for the disruptor to grow in the disrupted business, with realistic estimates of the challenges and costs that will be faced along the way. It is worth noting that most disruptors fail to change the status quo, and that the few that succeed often have setbacks along the way. It is easy to point to Amazon and Apple as successful disruptors, but these companies are the exceptions, not the rule.

1. China
What it really means:  A billion plus people, with rising incomes, is a very large market and any company that succeeds in this market should be able to generate large revenues and perhaps large profits.

In buzzword form: For many people, especially those not from Asia, the notion of a billion plus people in a market addles the brain. Thus, investors are quick to give a company that is China-based, one that has entered China or one that is even thinking about China a boost in market value. Companies, recognizing this impulse, are quick to play the China card, slipping it into investment announcements and earnings reports.

The key test: Preferred Competitor The Chinese economy is neither free nor open. The game is tilted towards one competitor over others, and that tilt does not necessarily reflect product quality. If you are the competitor preferred by the Chinese government, you will be a big winner. If not, you are just an also-ran, destined to invest large amounts of money in the Chinese market, with little benefit to show for it. For instance, in the contest between Google and Baidu to be the search engine for the Chinese market, Baidu starts off with a decided advantage as the preferred competitor and that translates into significant market share and large profits.

If you really mean it: Quantify the preferred competitor status, which will require you to understand political reality on the ground. You can start off with few presumptions. A Chinese company will be preferred over a non-Chinese one, and a Chinese company with good political connections will beat one without those connections. Analyzing the value of expanding into China requires you to be as much political analyst as valuation assessor.

Closing Thoughts

There are sensible uses for all of the terms that I have listed above, but unfortunately, the buzzword versions are the ones that I see more often in practice. In fact, I find that the people who are quickest to bring up a buzzword or use it to justify a premium often are the ones who have the shakiest understanding of it, leading me to put forth two propositions about buzzwords:

1. The Buzzword Count Proposition: My exposure to both equity research and buzzwords leads me to conclude that there is a negative correlation between buzzword usage and valuation quality. In other words, the more an analyst uses words like real options, disruption and China in talking about a company, the less substance there seems to be the actual research.
2. The Buzzword Swarm Proposition: The most dangerous challenge that you will face as investor will be when multiple buzzwords come together in the same news story. We have two IPOs coming up in the near future, Alibaba and Weibo, which will qualify under multiple buzzwords (strategic, growth potential and China at the minimum) and will undoubtedly be priced to deliver multiple premiums.

My resolutions for the near future are that I will use buzzwords sparingly, that I will not them use as a substitute for analysis, and that when I do use them, I will go the extra distance and try to work through the consequences.