Catalysts and Greater Fool Theory

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Once a security is purchased at a discount from underlying value, shareholders can benefit immediately if the stock price rises to better reflect underlying value or if an event occurs that causes that value to be realized by shareholders. Such an event eliminates investors’ dependence on market forces for investment profits. By precipitating the realization of underlying value, moreover, such an event considerably enhances investors’ margin of safety. I refer to such events as catalysts. – Seth Klarman

Feedback loops can be either negative or positive… a positive feedback process is self-reinforcing. It cannot go on forever because eventually the participants’ views would become so far removed from objective reality that the participants would have to recognize them as unrealistic. – George Soros

If you are not sure who the fool is in a trade or complicated investment, there is likely a fool and that fool is likely to be you. – Terrence Yang

Once in a while you stumble upon a crazed frenzy of people suddenly bidding the shit out of stocks within an extremely short period of time.

We’re witnessing it right now with the Hong Kong stock market.

Usually I don’t pay attention to such crazed frenzy since a bubble that’s been growing in size rapidly is still a bubble. I simply hate over-paying for things.

But what if the crazed frenzy is targeting under-valued stocks or stock markets? I’ve always thought the Hang Seng Index was under-valued before this crazed frenzy, either from an absolute valuation perspective [1][2] or a relative valuation perspective [3]. What stopped me from buying it was because I didn’t really like the quality of companies in the Hang Seng Index [4].

But when a catalyst like the crazed frenzy we’re now experiencing appears, it really piqued my interest since as Seth Klarman mentions, a catalyst that quickens a stock or stock market to rise to full value reduces risk for investors.

The risk with going into a bubble is momentum begets momentum, since people’s belief (we’re in a bull market) drives action (invest) that drives reality (bull market rises even more), which leads to a game of Greater Fool Theory. According to Investopedia’s definition of Greater Fool Theory, “it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.” So if I don’t have a game plan of when to go in and when to go out, I could become the fool in this game.

To prevent myself from being the fool, I needed to do fundamental analysis to make sure that: 1) My entry point is under-valued and 2) My exit point is full value. The reason being that if I entered at an under-value point, if I find myself still holding onto the stocks after the bubble bursts, it will still generate a decent return. The reason for exiting at full value instead of continuing to hold on until over-valuation is because the whole point of going in a bubble is to take advantage of a catalyst that realizes under-valuation to full valuation at a short period of time, so there’s no point to linger on after missions is accomplished.

Either way, as Mohnish Pabrai always says, “Heads, I win; Tails, I don’t lose much“.

Having decided I was going to play this game of Greater Fool Theory, three questions had to be asked. What do I invest in? What is the entry point? What is the exit point?

So what do I invest in?

I decided to forego individual securities. I have 7 Hong Kong stocks on my watchlist, but they were either over-valued or not in great financial health before this crazed frenzy even began.

Which left me with the Hang Seng index since I don’t touch individual stocks that I don’t follow myself, so a basket of stocks to protect myself against ignorance seemed like a good idea even though potential returns would diminish.

What is the entry and exit point?

My calculation of fair value of the Hang Seng index using 2015 March data was a range between $30.33 to $39.74. So my entry point was essentially any price below $30.33 and I would fully exit by $39.74.

And that is what happened. I’ve entered a position in Hang Seng Index at $27.70. I don’t foresee myself adding upon the position any further during this crazed frenzy. Let’s see how this turns out.

Footnotes

[1] eg. ~11 P/E as of today translates to 9% Earnings Yield. Even if you cut it in half into 4.5% Earnings Yield, it’s extremely likely that Hang Seng Index can grow 1.5% annually until perpetuity, ensuring at least a theoretical 6% return until perpetuity (Note that the Earnings of P/E is extremely easy to manipulate and volatile, so don’t 100% rely on P/E ratios. But for explanation purposes it is used as it’s easy to understand)

[2] A 6% discount rate is used if the risk-free US 10 Year Treasury Yield is yielding less than 6%. Right now it is at 1.96%. This benchmark is recommended by Joel Greenblatt.

[3] ~11 P/E compared to a mean of ~14.5 P/E. Historical P/E can be found here: http://www.hsi.com.hk/HSI-Net/HSI-Net

[4] Don’t get me wrong, Hang Seng Index companies are profitable and good. I just don’t think they are world class calibre (eg. Google, Visa, Mastercard).

[Disclaimer] Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

Currently holds stocks in Tracker Fund of Hong Kong (SEHK: 2800)

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