Value Vs. Momentum... The Law Of Perverse Outcomes
Bryant Gumbel, Tom Brokaw, tennis star Andre Agassi, Miami
Dolphins owner Wayne Huizenga, NBC President Bob Wright,
CMGI Inc. Chairman David Wetherell, and Joe Flom of the New
York law firm, Skadden, Arps, Slate Meagher & Flom. – all
these men were given an opportunity to buy ‘insiders’
shares of a company called Dreamlife, promoted by Tony
‘Awaken the Giant Inside’ Robbins.
What Mr. Robbins awakened inside these movers and shakers
was the craven little scamp, greed, not a giant of virtue
and achievement. And he did so by setting off an alarm that
awoke them with the opportunity to buy a $16 stock for just
$8. Even given a lock-up period of 6 months in which the
insiders couldn’t sell, this deal had to be what the boys
on Wall Street would call a ‘no brainer’.
Alas, dear reader, contrary to what you may have commonly
observed, even the absence of brains is no guarantee of
success in modern America. It is, of course, a big
advantage, but even near-perfect stupidity and ignorance
cannot be counted on to overwhelm the Law of Perverse
If ever there was a growth and momentum play, Dreamlife was
it. The company came out of nowhere with nothing and grew
to be worth hundreds of millions of dollars in almost no
time. Not only that, but its ownership list included some
of the most celebrated personalities and heavyweights in
the nation. Unburdened with a realistic business plan,
operations, profits or even sales…the stock floated upon
the steamy expectations of the manic market like greasy
bubbles on the surface of homemade soup.
But that was several months ago. Now, the heat has been
turned down and the price of Dreamlife shares has fallen to
$3. But even that price fits as awkwardly on the Dreamcast
business as a white dinner jacket on an Iowa hog. With
40,000 shares outstanding, it presumes a market
capitalization for the firm of $120 million. And yet,
Christopher Byron, Bloomberg columnist and my source for
this story, says that Chase Manhattan recently refused to
lend the company a paltry $1.5 million without an outside
The reason? Because Dreamlife is a nightmare that is about
to end. The company is going broke. In 18 months of
business, it has managed to lose almost $25 million on
sales of only $28,000.
The whole affair reinforces our belief in the
aforementioned Law of Perverse Outcomes. Somehow, sometime,
somewhere… people get, not what they expect, but what
they deserve. Things sort themselves out. It all comes
right in the end.
Victor Niederhoffer, speculator extraordinaire…until his
speculations produced such heavy losses that his hedge fund
went bust…challenged this view in an article that I first
thought was a joke…and still am not sure about.
“Why high P/E stocks are good for you” begins the headline.
In the thin air of a bubble market, the helium filled
stocks with high prices and low earnings, like Dreamlife,
may rise faster than their denser brethren. But
Niederhoffer seemed to be making a deeper point – that they
are ‘good for you,’ like broccoli or confession.
“Risk pays,” wrote Neiderhoffer, reinforcing the absurdity
of his point and making you wonder why he didn’t go broke
sooner, “and that’s why those risky growth stocks will
always be better for your portfolio than value stocks.”
Always? Risk pays when the real risk is over-priced…that
is, when the danger is exaggerated in the price. Bond
investors, for example, will find that their high yield,
junk bonds from Amazon are good investments – if the
company merely survives longer than the bond market
expects. By contrast, risk will not pay when it is
underestimated. If Amazon goes belly-up in 3 years rather
than the 4 years that bond investors anticipate, Amazon’s
bondholders will discover that particular risk did not pay.
Dreamlife shareholders seem to be as blind to risk…or
perhaps, as dull to pain… as Mr. Robbins’ firewalkers.
“Value is back,” Niederhoffer continues…perhaps with his
tongue so far into his cheek that he is in danger of biting
it off, “at the wrong time and the wrong place – just when
investors should be loading up on growth and momentum
Niederhoffer: “The main reason that growth investing will
always outperform value investing is that markets pay an
investor to lend long-term to companies with above-average
rates of return. That’s the process that leads to assets
being deployed in their best possible uses. And that’s the
process that all stock exchanges show in their films to
visitors to explain this. But strangely, the message has
No one doubts that investors generally get a return on
their money from investing…nor even that there is some
relationship between risk and reward, but that does not
mean that investors don’t occasionally over-invest in risky
projects, reducing the yield per dollar of investment – and
do not sometimes misjudge the real risk involved.
Niederhoffer and a colleague studied the returns from
Nasdaq 100 stocks over the last 3 years. They found, not
surprisingly, that when the wind picks up – as it did since
1996 – the Dreamlike fluff flies high. In fact, those
Nasdaq stocks least freighted with earnings rose most. From
this he might have drawn the conclusion that the last 3
years were unusual. Instead, he seems to think that what
happened between 1996 and 2000 might continue forever –
that is, that the most expensive companies (per dollar of
earnings) will forever become even more expensive…a
hypothesis so unlikely that it ranks alongside classics,
such as: “I didn’t inhale.”
“High P/Es are good P/Es,” Niederhoffer concludes…and “we
intend to place some of our hard-earned cash from writing,
and perhaps a few more from savings, into a little
speculation on the least value-full of the Nasdaq 100.”
If the next three years, are like the last three,
Niederhoffer may be able to complete a full cycle…from
genius to fool to genius again. And who am I to say that he
But the Rehabilitation of A Speculator could also take much
“After a portfolio of growth stocks is identified,” said
Bill Bernstein, quoted in Grants as he put his finger on
Niederhoffer’s LPO problem, “it becomes less profitable
with time, and after a portfolio of value stocks is
identified, its profitability improves.”
Mass recognition is the last step in a financial cycle –
before it reverses direction. Thus, not until everyone
becomes aware that Niederhoffer is a fool will he become a
genius again. And not until everyone becomes fully
convinced that the bull market is over, then – it will be
ready to begin a new climb.
Companies that everyone knows are declining in terms of
growth and profitability do the obvious thing – they cut
expenses and hustle for extra sales.
Meanwhile, companies that everyone knows as growth stocks –
with rising earnings and profits – “become complacent,”
says Bernstein, “and tend to waste capital and decrease
profitability… Thus, the long-term historical superiority
of value, with its rising profitability… over growth,
with its deteriorating profitability.”
But Bernstein goes on to make a deeper point. “All
investments,” he says, “…have two return components – the
investment return and the entertainment return.”
Daily Reckoning aficionados, if there are any, will
recognize in Dr. Bernstein, a companionable soul. You may
recall, months ago, that I suggested that dot.com and tech
investors had a motive other than money. They were
sacrificing themselves for the public good, I reckoned that
day, figuring that they were over-investing their money so
the new technologies would be built out more quickly than
would be economically sound. They were like the Kamikaze
pilots of Japan in WWII – caught up in the mass madness and
willing to go down in flames for the cause. They did so,
not by reason, but by instinct…so that the rest of us
would enjoy the fruits of the new tech sooner than
And at least they could feel good about themselves, even
superior to the rest of us. With a flashlight of cash, they
were helping to usher in the New Era.
Bernstein puts it differently:
“The purchase of a bubble stock has a high entertainment
return, but this unfortunately crowds out most of the
investment return. Investors accept low investment returns
on tech stocks, I believe, for the same reason they accept
low returns form a trip to Las Vegas – they derive
considerable entertainment from it.”
More particularly, growth stocks…even goofy ‘growth’
stocks like Dreamlife…allow investors feel superior. They
are with it; they get it; they are hip to the New Era –
forward-looking Digital Men, with modern art on their walls
and a palm pilot in their pockets.
But it’s expensive entertainment.
October 16, 2000
P.S. If the general proposition is correct – that is, if
things balance out in life…then just as you would pay a
price for owning attractive growth stocks…you’d expect to
be rewarded for owning unattractive value ones. This might
be the same phenomenon that allows buyers of modern art to
make a profit – they are rewarded for putting up with
“There are stocks,” says Bernstein, “that scare the
bejabbers out of us, which can be thought of as having
negative entertainment value, for which we are thus
rewarded with return in excess of the market.”
Tomorrow – some of the most unappealing stocks in America.
Take these ugly puppies home and they will be your most
loyal and trustworthy friends…fetching profits for as
long as you own them.
*** Alan ‘Harry Potter’ Greenspan met with his little band
of central banker magicians yesterday. They neither raised
nor lowered interest rates, as expected. But they didn’t
move to a neutral stance either, which disappointed Wall
Street, especially the financial stocks.
*** The Fed said that the battle against inflation was not
entirely over. Meanwhile, “evidence of a slowdown mounted”
said the Financial Times, “with … a decline in factory
output, an abrupt slowdown in stockpiling among retailers,
wholesalers and factories, and a weakness in the loan
portfolios of major U.S. banks.”
*** Stocks nevertheless managed a modest rise yesterday.
The Nasdaq gained 27 points. The Dow gained 26.
*** 1656 issues advanced on the NYSE; 1188 declined. 74 hit
new highs; 62 hit new lows.
*** Investors are still believe in the power of stocks to
make them rich…and in the magic of the Fed Chairman to
make sure nothing goes too seriously wrong.
*** Abbey Joseph Cohen says “stocks are at their best
values of the year.” This is, of course, undeniably true.
But the question is whether or not they will be even
greater values in the months ahead.
*** The trouble is that stocks are still far too attractive
to investors. They are still pouring money into mutual
funds, and still willing to go into debt to buy shares – on
the theory that capital values will rise faster than the
cost of credit.
*** Richard Russell reports that margin accounts have
fallen from their peak of $278 billion at the height of
Nasdaq mania in March to $233 billion today. But Russell
cites the work of Dr. Sloan Wilson who said that a bear
market should reduce margin accounts by 90% – which would
give us a target of just $27 billion for margin debt when
stocks are ready to head up again.
*** Also from Russell: “The Dow Jones World Stock
Index…has formed a huge top, then…broke sharply below
its May low. This suggests to me that a world economic
slowdown is on the horizon… The next U.S. president is
not going to have a picnic.”
*** Oil is at $35.48 after rising 71 cents in N.Y.
yesterday and dropping back a little in trading in Asia
*** There was little action in the currency markets. The
euro still refuses to rise and the dollar refuses to fall.
*** “We have just not even begun to appreciate the effect
of biotech on culture and on society,” observed Greg
Blonder in Barron’s. “I think we have completely
underestimated its impact,” said the former MIT scientist
with 70 patents, now a venture capitalist.
*** “Could biotechs become the market’s next dot.coms?”
asks a Barron’s headline. Blonder and a lot of other people
think so. “Since mid-1999,” writes Michael Shaoul, Vice
President of Oscar Gruss & Son, “the biotechs have
generated impressive gains and, even in the face of the
market’s recent volatility, a number of them remain at or
near all-time highs, while many of their brethren in other
areas of the tech universe have been battered.”
*** As with the rest of the tech universe, very few
investors understand what happens on Planet Biotech. But
they have heard that the new technology may be able to
perform wonders – such as growing new organs and greatly
extending the human lifespan. Surely there must be money to
be made. And since investors are sure that there is a
fortune waiting for them somewhere …why not in the
*** “Nevertheless,” writes Shaoul, “the economic value
being placed on the companies at the center of these
achievements isn’t founded in reality…the group is being
over-valued on a fundamental basis…”
*** PC makers fell yesterday, while Intel and Micron rose.
William Fleckenstein comments on the ‘disconnect’: “It was
as if they were pretending they were just names, and not
businesses that make the parts that go into PCs….. In my
opinion we are not too far away from pre-announcements in
PC land – probably starting sometime in the next couple of
weeks. In this quarter, folks are finally going to come to
the conclusion that PC stocks deserve much smaller
multiples because it’s a terrible business, arguably no
better than making televisions or some other consumer
*** “While the Internet/telecommunications/technology
bubble is in the process of collapse,” writes David Tice,
“the dangerous real estate bubble is running unabated. The
Mortgage Bankers Association reported that mortgage
applications increased almost 6% last week to its highest
level since June of last year. Considering the historic
mortgage-lending boom, there should be little surprise that
home construction remains quite strong and housing
inflation continues to accelerate in many markets.”
*** We had a long day yesterday – taking the train over to
London in the morning and back in the evening. We had
intended to stay overnight – but the hotels were sold out.
*** Addison had never been to High Tea in London, so we
continued our meetings at the Savoy (Brown’s was booked).
There is probably some unwritten rule against discussing
business matters at tea, but the whole experience has
drifted down market in recent years anyway – as tourists
from all over the world rush to London’s grand old hotels
to empty their pockets in front of liveried attendants and
*** A few tables down from us, two women looked like they
might have walked right in from Boone’s Mobile Estates in
Upper Marlboro…while at an adjoining table a man who
looked as though he lived before the introduction of
mirrors, sat without friends. There was no one to tell him
that he looked ridiculous and he couldn’t see for himself.
*** But the experience had its uplifting moments, too. On
the other side of the room, a decrepit man fondled the hand
a beautiful young woman who reminded me of a Vargas Girl
pinup. The man – at least 20 years older than I am, and
probably a half-century older than the woman – gave me hope
for the future. If something should happen to Elizabeth,
perhaps I will be able to make a fool of myself too.