Memes Are Analytical Weapons of Mass Destruction

It’s been said that a clever phrase can stop people from thinking for a whole generation. In the world of investing, clever phrases abound. And investing against the grain can be a difficult and gut-wrenching experience.

The impulse works both ways. There is competitive pressure to participate in a security when everyone else is bullish, lest you get left behind. Lagging portfolio performance makes you look bad and threatens your job. Likewise, there is competitive pressure to avoid the securities that everyone just “knows” are dogs. When a widely trusted name goes down, it’s the company’s fault. When an unknown issuer’s price goes down, it’s yours and yours alone.

Of course, when it comes to investing, memes (an idea that spreads from person to person within the market) can be either right or wrong. But investing based on popular memes is an analytical weapon of mass destruction. And going against the grain can be a gut-wrenching experience. But going with the grain is wrought with risk — especially when market perceptions change to acknowledge reality. Knowing how to navigate this landscape of perceptions is the wisdom of investing.

Consider the case of Enron Corporation. Before Enron became synonymous with fraud and self-dealing, it was a darling of Wall Street. As of March 2001, just eight months before declaring bankruptcy, Enron had a P/E ratio of 55 times earnings and 18 buys from sell-side analysts on Wall Street (before Wall Street analysts had lost some of their cachet). This era was still the dot-com bubble days, and the phrase that stopped a whole generation of analysts from thinking was “new economy.” And Enron was it. They were on the inside. They were the new economy. That was the meme.  Anyone that didn’t get it was on the outside. Morons. Losers. Luddites.

• “For Enron to say we can do bandwidth trading is like Babe Ruth saying, I can hit that pitcher. You tell him to get up there and take three swings. The risk is staggeringly low, and the potential reward is staggeringly high,” Steven Parla, energy securities analyst at Credit Suisse First Boston, said. (Fortune, 24 January 2000)
• “What’s new is that Enron is trying to make bandwidth a commodity. Absolutely, it will succeed. I think everyone wins,” Brownlee Thomas, a senior telecom industry analyst for Giga Information Group, said. (Fortune, 24 January 2000)
• “Enron has built unique and, in our view, extraordinary franchises in several business units in very large markets,” Goldman Sachs analyst David Fleischer said. (Fortune, 5 March 2001)

What the subsequent collapse makes painfully clear is that very few people actually understood exactly how the company worked — how it was financed, how it made money. The moment the financing scheme was made public, it was a laughable farce. Healthy skepticism in the investment community had been replaced by suspended disbelief. And if you didn’t get it, you were “too stupid” to understand how the world was changing.

Of course, change works both ways: for the better and for the worse. CFO Andy Fastow pledged Enron stock as collateral against a wide variety of financing arrangements. Consequently, when Enron’s stock took a material hit with the popping of the tech bubble in 2001, the company was forced to pledge more and more stock to support these loans. This financing scheme was part and parcel to how senior executives were enriching themselves at shareholder expense in less than arm’s length transactions.

We tend to presume that large public companies have enough interested parties to prevent gross self-dealing like this, but alas, Enron stands as an example of the limits of our knowledge (and financial disclosure). Moreover, it takes a strong person to admit that they don’t understand something about a company they are following, especially when their paycheck is derived by telling people that they do.

Now consider the US housing and subprime mortgage bubble in 2000s. The phrase that stopped another generation of investors was that subprime difficulties were “contained” or that home prices had “never fallen on a national basis since the Great Depression.” Of course, the subprime difficulties were not contained. These were just words, phrases, ideas . . . memes.

• “. . . Nominal [home] prices in the aggregate have rarely fallen,” Alan Greenspan said at a Council on Foreign Relations event on 10 March 2005. (New York Times, 22 August 2007)
• “It seems to be the case — there are some straws in the wind that housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate; that house prices will probably continue to rise but not at the pace that they had been rising,” Ben S. Bernanke said at a House of Representatives hearing on 15 February 2006. (New York Times, 22 August 2007)
• “I also said I thought in an economy as diverse and healthy as this that losses may occur in a number of institutions, but that overall this is contained and we have a healthy economy,” Hank Paulson, secretary of the Treasury, said in the summer of 2007. (Slate, 6 August 2007)
• “These sorts of things are what’s known to the academics as ‘endogenous to the system’ — that is to say, they’re normal. They happen usually every three to five years. So we had a freezing up of the market for corporate credit in the summer of ’02. We had an equity bubble just before that. In ’98 we had Long-Term Capital. In ’94 we had a mortgage collapse like we’re having right now. In 1990 we had an S&L collapse. In ’87 we had a stock market collapse. These things flow through the system, and they’re part of the system. I saw one quant quoted over the weekend saying, ‘Stuff that’s not supposed to happen once in 10,000 years happened three days in a row in August.’ Well, I would think that you would learn in Quant 101 that the market is not what’s known as normally distributed. I’m not sure where he was when all these things happened every three or five years. I think these quant models are structurally flawed and tend to exacerbate this stuff,” Bill Miller of Legg Mason Value Trust said on 17 August 2007. (CNN Money, August 2007)

After these memes were presented by a gauntlet of highly respected financial professionals, we then heard and saw these assurances repeated ad nauseum throughout the financial media, from Wall Street analysts, and among many investors. Very few people were in a position to see exactly what was going on in banking, housing, securitization, financial markets, monetary policy, globalization and government policy. Fewer still possessed the expertise to appreciate how destructive the combination was.

While people can maintain optimism before everything falls apart, they can also maintain their pessimism even as the world is changing for the better. Consider the case of International Business Machines (IBM) in the 1993–1994 time frame. It was widely believed that IBM had lost its cachet as clone-computing upstarts in the PC market, and Microsoft, were extracting value from the tectonic shift in the computing market toward desktop PCs. IBM was labeled with, not one, but many phrases — such as bureaucratic, behemoth, slow, colossal, impossible — that all essentially meant the same thing: IBM had become too big for its own good. After having reached a high of $187 per share in August 1987, it sunk to $49 in April 1993 when CEO John Akers retired and Louis Gerstner took over.

• “[An implosion] is a real possibility . . . unless they get a grip,” Charles Ferguson, an industy analyst, said. (Newsweek, 8 February 1993)
• “IBM has become a company riddled with blowhards and bureaucrats who have used their brain power to entrench themselves in the corporate structure in the same way a barnacle glues itself securely to a boat hull. IBM bureaucrats, like barnacles, move slowly and obstruct each other,” John Dvorak wrote in “A Open Letter to Gerstner.” (MC: Marketing Computers, July/August 1994)
• “I have said for some time that the problem of failing organizations is that they are over-managed and under-led. At one of IBM’s erstwhile factories in Lexington, KY, now run successfully by Lexmark International, the former IBM workforce placed in its lobby a large sarcophagus in which all the former IBM practices, policy statements and standard operating procedures are embalmed for all to see.” Warren Bennis, professor of business at the University of Southern California, wrote in July 1993. (Management Review, July 1993)

Just as the ink was drying on many of these printed quotes and establishing the “too big and slow for the technology industry” meme in the market, IBM was engineering a dramatically successful turnaround. Gerstner went on to become one of the most successful CEOs in corporate history, taking this large, bureaucratic company and reshaping it into a global IT services and advanced technology juggernaut. While many people popularly criticized IBM during that era — including many inside the IBM organization — it took an outsider (Gerstner) to recognize the value and deliver on it.

It’s not necessarily that the people quoted here were wrong, per se. Rather, their comments act as a sort of living testimony that things change. Businesses change. Perceptions change. And yes, people change.

When you identify a material discrepancy between the market’s perception of a situation and the changing reality of a situation, you can better understand market risk and opportunity. It seems we humans make things more difficult by listening to others’ opinions and not doing our own analysis of the facts. We can acquire the wisdom we need without enduring the harsh lessons of failure. We just need to be honest with ourselves about what we know — and what we don’t. And then compare that to market perceptions — and invest accordingly.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.