Madness Of The Crowds

Have you ever been to a storage unit auction?

I’m sure you’ve watched Storage Wars and have an idea of how these things work. The concept is pretty simple. When a renter abandons a storage unit or is delinquent on rent, the storage facility has the right to auction off the contents of the abandoned unit. There’s just one catch. Storage unit auctions are blind auctions. The winning bidder is buying sight unseen.

From what I’ve observed, there usually isn’t any rhyme or reason to the bidding other than the size of the storage unit and location of the facility seeming to be somewhat important factors in the process.

Bigger storage units in nicer areas seem to command higher bids while smaller units in sketchy neighborhoods draw less interest. Other than size and neighborhood, it seems like the wild west.

Once in a while, you’ll see bidding skyrocket on a unit for no apparent reason other than a rumor circulating among the crowd. “I heard this unit was owned by a millionaire who just passed away. He had no family or heirs but some people are saying he kept a Ferrari or maybe a Porsche in here.”

Sometimes bidders will just go with the flow when they see one or more bidders with an intense interest in a particular unit. Everyone keeps trying to one-up each other until there’s only one left standing. Everyone’s trying to strike it rich at these storage auctions but the truth is most people will end up with DVD collections, kitchenware, and other everyday items.

Every once in awhile, someone will stumble on recreational vehicles or a valuable antique, but for most people, it’s a recreational activity – not a profitable one.

Storage unit auctions remind me a lot of the stock market.

Stock prices for the most part aren’t determined by the underlying value of the company. They’re more a function of investor demand and sentiment.

Like storage auctions, stock prices for the most part are driven by what the next person is willing to pay for them. Hype and rumors play a big part in driving up a stock’s price just like the winning bid on a storage unit.

If people knew the content of the storage units they were bidding on, winning bids would more accurately reflect the value of the contents. The same should go for stocks. Stock prices should reflect the underlying value of the companies they represent. But that’s just not the case.

Retail investors completely ignore the underlying values of companies when buying and selling stock. They treat buying and selling stock more like gambling – more interested in timing the market to buy low and sell high.

Although analysts have different valuation methods for evaluating the value of a particular stock, these methods are often ignored by the investing public.

Take, for example, price to earnings ratio (PE Ratio). The PE Ratio is often used by analysts to determine whether a company’s stock is overvalued or undervalued. The PE ratio measures the average of a company’s stock price compared to its earnings. A price disproportionately higher than earnings indicates overvalue.

The Dow as a whole has historically traded at a PE ratio of around 15. By contrast, the Dow is currently trading at a PE ratio near 28 – nearly double the historic average. This is saying the stock market is overvalued and in dangerous territory.

Earnings seem to be a fair measurement of a company’s value. Logically, profitable companies should be worth more than companies operating in the red. That’s the idea, but retail investors just don’t operate that way. They ignore underlying fundamentals – relying instead on the latest rumors circulating on the web and social media and prognostications from cable and internet talking heads.

The result is a market ruled by the madness of crowds and rampant volatility. And with modern investing, social media has taken on a significant role contributing to increased speculation and volatility.

Regarding the impact of social media on stocks, the authors of a recent research paper made the following observation:

“We find that stocks with large social media buzz have significantly higher idiosyncratic volatility and higher trading volume over the next month. Relative to a stock with no social media buzz, the most talked-about stocks on social media experience an increase in their average volatility of about 50%, and an increase in average trading volume of 25%, over the next month.”

The madness of the crowds has taken over the market unlike in any other time period in our history since COVID-19 landed on our shores in February. After shedding almost a third of its value in March due to nationwide lockdowns, the stock market has come roaring back in strange and unpredictable ways – none of them good.

Expert upon expert has been sounding the alarm since June about the overvaluation of the market and an impending crash. Investors don’t seem to be heeding the warnings though.

The COVID-19 pandemic and the new social norms brought about by its devastating effects has created a new breed of investors who treat the stock market as a virtual Vegas – investing with even more abandon than any other crazed mobs have ever done on Wall Street – including the Dot Com and Mortgage-Backed Securities eras.

It seems this breed of investor not only doesn’t care whether they win or lose but actually relishes in amassing losses. With easy and convenient mobile transactions along with commission-free trading platforms like Robinhood, it has never been easier to play the market – virtually rolling the dice with no clear strategy or goals in place.

It’s clear these small traders don’t know what they’re doing and truly rolling the dice on their futures. That’s the only explanation for the surge in demand for risky stocks, including Hertz and Chesapeake Energy, both of which have filed for bankruptcy.

An Alternative to Mob Valuation

I’m leery of entrusting my financial fortunes to the madness of the crowds where the value of what I’m investing in is based more on emotion and mob mentality than on any underlying economic fundamentals.

Market volatility and unpredictability makes it hard to make and execute a financial plan when there can be no assurance of ever receiving a return on investment.

I prefer more predictability. I prefer real assets that have value based on underlying economic fundamentals – assets like commercial real estate and income-producing assets that have verifiable financial data essential for making an investment decision.

Take commercial real estate for example. The value of commercial real estate is based less on what the masses are willing to pay for it and more on the expectation of returns and profits that an asset can generate.

Two of the most popular valuation methods involve calculations:

1. Cap Rates.

1. Internal Rate of Return (IRR).

Cap Rate.  A property’s Cap Rate is a common valuation method used by commercial real estate investors. Cap rates are useful for forecasting what an investor can expect to make in the first year of an investment because it’s based on actual current year financials.

The cap rate is calculated by dividing the most recent year’s Net Operating Income (NOI) by the purchase price. Assuming nothing changes, an investor can expect a return equal to the Cap Rate in the first year of investment.

For example, if a property generated $800,000 of NOI in the most recent year and the property is acquired for $8 million, the initial cap rate is 10%.

In simple terms, without taking into consideration the time value of money, a property with a 10% cap rate can expect to return 100% of an investor’s initial investment capital in 10 years.

The cap rate is useful as a snapshot of what an investor can expect in the short-term. Cap rates are useful for comparing the relative values of similar properties in a given market. For two nearly identical properties, the property with a 10% Cap Rate is more appealing than one with an 8% Cap Rate.

All things being equal, the higher the Cap Rate, the sooner you can expect a return on your investment. It’s also useful for benchmarking one property against another in the present. but it doesn’t take into consideration value-add opportunities or long-term returns.

IRR.  For more accurate valuation, commercial real estate investors prefer calculating the Internal Rate of Return (IRR).

In technical terms, IRR is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equals zero.

Here’s the mathematical formula for calculating it.

0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n

where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and

IRR equals the project’s internal rate of return.

What is IRR in layman’s terms?

Think of IRR as the compound interest rate an investor can expect to earn on an investment. A typical CD earns a 2% compound rate to give you some perspective. A property with an IRR of 10% is offering an excellent return. IRR is valuable for a commercial real estate investor because they can factor in value-add initiatives that impact cash flow and it takes into consideration the time value of money (i.e., inflation).

Business Valuation

There are a few methods for valuing cash flowing businesses but the one that takes into consideration cash flow like IRR for commercial real estate is the discounted cash flow methodology calculating the net present value (NPV) of future cash flows for an enterprise.

If you invest $100,000 and the NPV of five years of cash flow is $100,000, that tells you that it will take five years to break even.

For valuing the feasibility of an investment opportunity, I prefer dealing with concrete numbers and solid underlying economic fundamentals.

I prefer real assets like commercial real estate and cash flowing businesses where the cost of acquisition is based on potential cash flow.

With the stock market, the price you pay for a stock may have nothing to do with anything other than current investor sentiment.

I’m a terrible gambler and I prefer not to entrust my investing fortunes to the madness of the crowds. That’s why I avoid Wall Street for assets with real value.