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Strategies & Market Trends : Gorilla and King Portfolio Candidates -- Ignore unavailable to you. Want to Upgrade?

To: Mike Buckley who wrote (16878)	1/31/2000 10:48:00 PM
From: om3	Read Replies (2) \| Respond to of 54805

Mike, Thanks for joining us! We look forward to having you around, especially if you continue offering such cogent thoughts and questions. Thanks! I've enjoyed your comments. Second, let's assume enough people really do "get it." Knowing how rapidly Gorillas grow over long periods of time, what would be so bad about buying a Gorilla that is fairly valued all the time? Such a stock would still outperform most investments and with an extraordinarily low degree of risk relative to an extraordinarily high degree of safety. The problem is that if the market is efficient it will price a stock so that the return is just the risk-free interest rate plus a premium for risk. So even if the company is growing at a tremendous rate, the efficient market price will be so high that the stock price only grows at a boring rate. To understand the argument for this I find it easiest to think about the case with no uncertainty or volatility. Let's say the only two investments in the world were a risk-free bond paying 6% and Gorilla Inc., a company just about to enter its tornado. Let's say that it is guaranteed to grow exactly 50% per year during the tornado and that everyone knows the tornado will last for exactly 10 years. At the end of 10 years it will stop growing faster than the market and will start paying a dividend of 6% of its book value per year. Let's say that it starts with a book value of $1M and it issues 1M shares. What will an efficient market price the shares at and at what rate will the share price appreciate? After the 10 years of tornado growth, the book value of the company will be (1.5)^10 * $1M = $57.7M and since from then on it will pay the 6% risk-free rate, it is worth $57.7 per share at that point. How much is 1 share worth today? We need the value of $57.7 discounted ten years to the present. This is: $57.7/(1.06^10) = $57.7/1.79 = $32.2. Why will the market push the price to this value? If shares were cheaper than this then people would sell their bonds and buy Gorilla Inc. since they get a better return and we're assuming there's no risk involved. If shares were more expensive than this, then people would sell Gorilla Inc. and buy bonds. So what happens to the stock price of Gorilla Inc. over the 10 years of the tornado? It starts at 32.2 and grows like this: 32.2 34.1 36.2 38.4 40.7 43.1 45.7 48.5 51.4 54.4 57.7 So even though the company is growing at 50% per year, the stock only grows at 6% per year. Bummer! Of course, this analysis is very dependent on everything being known at the start and there being no uncertainty. For example, the proper initial price is extremely sensitive to the exact length of the tornado. If it lasted for 20 years, then the current price should be (1.5/1.06)^20 = 32.2^2 = $1036.8. It's also pretty sensitive to the risk-free interest rate. If it had been 8% then the proper market price would have been (1.5/1.08)^10 = $26.7 (hence all the attention to the Fed). So why is it that in the real world gorillas seem to do so well? I like your comment about the emotionalism in the market. I would guess that would be especially applicable to gorillas since their high P/E ratios make them especially scary. I also like tekboy's notion of good news happening with greater regularity for good companies. The Gorilla advantages structure it so that much of the uncertainty in the performance distribution are way to the upside. It also seems that the market is somewhat myopic. The Motley Fool's Rule Breakers, Rule Makers book claims that it really only sees events about 6 months in advance. As has been discussed here many of the Gorillas manage to start tornado after tornado and to leverage their positions in earlier tornadoes to build the next one. Clearly the market can't predict that. But then again if everybody believes that that's how Gorillas behave they may start pricing them beyond what they can see. This is like the "options pricing" argument for Godzillas in chapter 12 of the RFM. We may not see how they're going to do it but we're willing to pay for possibility that they'll be in a good position to exploit the future when it arrives. Of course, that kind of thinking can lead to an arbitrarily high present value. Christensen's book "The Innovator's Dilemma" gives many examples of once powerful companies brought down by little upstarts with innovative technology. As a final guess, maybe the gorilla market currently is efficient and it's just that the uncertainties are so great that they warrant huge returns. For example, in the simple model above what if it was a 50/50 chance that Gorilla Inc.'s tornado would last 10 years or 20 years. Then the uncertainty distribution over current price would have half its weight at $32 and half its weight at $1037. This is a huge variance. The market would probably start the stock well above $32 but move very gradually up toward $1037 as the business facts became more clear. If something like this is really the explanation, I'd sure like to understand it in better detail. --Steve

To: Mike Buckley who wrote (16878)	1/31/2000 10:59:00 PM
From: mauser96	Read Replies (2) \| Respond to of 54805

Mike, reading between the lines of your post ' I get the idea that you think the market is mostly efficient most of the time, but becomes inefficient at extremes and times of crisis or panic. If so, its the same as my opinion. Since the stock market is composed of thousands of stocks, it's not enough to talk about the market as a whole like the academics tend to do. We have to talk about individual stocks, and QCOM is a good example. Almost everybody now agrees that the QCOM*ERICY deal was a seminal event in the QCOM story. If the market was efficient the price would have completed it's climb in seconds. A study of the thread at the time shows that different people reacted in different ways and at different times so delayed the full runup. This wasn't efficient. This also shows that these rare periods of inefficiency are good times to make money.