In my research into capital markets over the past couple years, I've consistently bumped into the concept of the "wisdom of crowds", which in its inverse can be referred to as the "madness of crowds".
This is a concept that I’ve given a lot of thought to over the past few months, especially when thinking about the efficiency of the stock market in general. Earlier this year, I read a book titled The Wisdom of Crowds by James Surowiecki. I first discovered the concept of the “wisdom of crowds” while watching a video course on markets and finance published by Great Courses Plus, yet another source of my informal finance and economics education. In that video, the lecturer described a professor he once knew that passed a jar of gumballs around a classroom of maybe a few hundred students. Each student was required to guess the number of gumballs in the jar. The lecturer did this each year, and quite consistently, the average guess of all students’ guesses was remarkably accurate. In addition, almost no students on average ever beat the class average guess in terms of proximity to the actual number of gumballs in the jar. In his book referenced above, Surowiecki portrays a number of situations in history that have played out in a similar context, including an example almost identical to the one above. In summary, he describes situations where the collective wisdom of crowds is more accurate than most or any individuals in those crowds, regardless as to the degree of expertise they possess individually, even when the crowd included subject matter experts. Surowiecki goes on to describe the conditions required for such a situation to benefit from the wisdom of crowds concept. He lists the following as prerequisite conditions for a crowd’s judgement to be accurate:
- Diversity of opinion - each person should have some private information, even if it’s just an eccentric interpretation of the known facts
- Independence - people’s opinions are not determined by the opinions of those around them
- Decentralization - people are able to specialize and draw on local knowledge
- Aggregation - some mechanism exists for turning private judgments into a collective decision
If you believe these prerequisites seem to be a good description of the public equities markets, I tend to agree. Returning to the market process concept discussed in an earlier post, the first step in the process was that separate entities or individuals compute intrinsic value of a company’s stock to determine whether there is sufficient margin of safety for them to purchase the stock, in hopes that it might appreciate in its move toward its real intrinsic value in the future. In effect, the collection of all market participants becomes the crowd and because of their diversity of opinions, independence, decentralization and the market’s ability to aggregate their collective opinions of intrinsic value, we have mostly efficient markets that provide an output of price value that theoretically is closer to true intrinsic value than any experts could determine individually. The reason this works well is that all of those market participants, by performing their own separate calculations of intrinsic value, and transacting at agreeable prices are contributing information to the market. Surowiecki points out that at the individual level, each of these participants is likely contributing some actual information, along with some bias or error. When all participants’ contributions are combined, ideally the collective error of some offsets with conflicting error contributed by others and the remaining net value is actual, valid information which builds and compounds with additional participants. If the prerequisites listed above are met in the environment, that net information that is left over after the bias or error is netted out is generally quite accurate at describing reality. This is how the output part of the market process provides value to market participants and is also quite possibly why market returns in general are so tough to beat. In order to outperform the collective market, an individual must generally be lucky, have some sustainable statistical edge or simply know more than the collective wisdom of the rest of the investing world, which is generally unlikely. One caveat to this is that all market participants are generally subject to the same behavioral biases, so a general understanding of those is needed to be able to capitalize on them in order to be able to outperform the market.
Factor investing at its core tends to measure the most consistent behavioral biases in an attempt to identify investments that are poised to outperform the market. For example, the value style factor measures stocks whose prices are low relative to fundamental profitability or balance sheet metrics in order to secure a margin of error when investing. Historically, buying stocks with the lowest valuations has tended to outperform the general market in most economic environments. Therefore, this investing approach could be said to have found a sustainable statistical edge versus the general market.
Another observation that is commonly made along these lines is that securities that are widely held and traded frequently are more likely to mirror their true underlying intrinsic value than are securities that are less widely held and infrequently traded. Said another way, capital markets are generally more efficient for highly liquid large company stocks than they are for thinly traded smaller company stocks. Liquidity is partially to blame for this (fewer buyers and sellers exist, so they meet less often), but so too is fact that there is simply a smaller crowd convening to determine market value. A smaller crowd generally has less "wisdom of the crowd" knowledge or effect than a larger crowd due to the potential for less offsetting of the bias or error inherent in market participants as well as less contributed actual information. From this, we might conclude that it should be easier to find market inefficiencies ("good deals") the further we move away from the largest capitalization companies and toward the smaller capitalization companies because the crowds trading a the smaller capitalization range are smaller and thus have "less wisdom".
This is even more pronounced in private markets where the crowd size is minimal and liquidity is all but non-existent. To that end, we at Triobe Management have recently launched what we're calling a "micro private equity" venture where we're looking to make equity investments in small, successful operating companies in Upstate South Carolina to capitalize on our collective experience, both in business management as well as investment management. We do not intend to be operators, but rather we intend to augment current ownership/management's ongoing success by partnering with them to seamlessly transition their business to the next generation of ownership. We have identified a growing trend of baby boomers looking to retire from their long held businesses with a manageable and predictable exit. We believe our model will work well for this population that will only grow over the next couple decades. Our investment horizon is not limited to three or five years as is generally the case in private equity, but rather we intend to hold our equity interests indefinitely as each case warrants. If you or someone you know is looking to transition out of ownership of a closely held business in the Upstate, please contact us for an introductory conversation.
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