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It May Be Too Little Too Late

publication date: Feb 1, 2021
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author/source: Brian Nelson, CFA
January 29, 2021
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Hi everyone,
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Brian here. This was a huge week for Valuentum. I must say that I've been quite distracted by the market activity. The share-price moves that we've seen in companies such as GameStop (GME), AMC Entertainment (AMC), and dozens upon dozens of others have been unbelievable.
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It has also come to my realization that no matter how good we are, or how many absolutely huge calls we get right in advance--from value vs. growth and the "quant" value factor in 2020 to the price-agnostic trading frenzy we've seen so far in 2021--that we're not going to get much media attention. 2020 was our best year as a company, by far, and we're crushing it as a firm, but still it's a big personal let down. I'm hopeful we still may get some buzz on the second edition of Value Trap.
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But times are slow. Nobody's talking fundamentals these days. Many are playing the market like a casino on social media or joining other platforms on Reddit or elsewhere. That's part of the reason why we're doubling down to help our dedicated members with plans for Pigeon Oak Capital Management in the future. We want to serve you the best we can, especially in the types of markets that we think may be coming.
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As you have probably gathered thus far, we're likely past the tipping point with respect to price-agnostic trading (i.e. trading that's not based on price-to-fair value analysis). We're hearing all sorts of talk about market regulation to stifle WallStreetBets (WSB), but there may be no way to do so. Quant investors, index funds, and most ETFs aren't trading on estimates of intrinsic value either, and most of the Nobel prize winning work in finance is based on price-agnostic trading, too, from modern portfolio theory to the efficient markets hypothesis that backs indexing and beyond.
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The outlook isn't bleak, per se, but there may be no way to stop the markets from going completely bonkers in the years ahead. Volatility could continue to surge just as we had outlined in Value Trap. For one, the WSB subreddit continues to grow rapidly with the publicity it has garnered, and combined with trend and momentum quants, the breaking down of the price-discovery mechanism in the markets that we warned against in our "Call to Action" in Value Trap may finally be coming to fruition.
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I won't pull quotes from the book as reference, but we all saw this price-agnostic trading frenzy coming a mile away. WSB and the quants are now moving companies like GameStop with a ~$20-$30 billion market capitalization like they are penny stocks. With new social technologies, we have all the makings of a marketplace that we've never witnessed before. Of course, the markets have always been volatile and risky, but what we could be headed for may again stretch levels of volatility that we never thought possible.
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In March 2018, I wrote to appeal directly to this new generation of investors that are now, themselves, participating in price-agnostic trading. There are real social consequences including 1) jeopardizing the attractiveness of the capital raising function of the markets, 2) creating a further divide in wealth inequality, 3) reducing the underlying investment options for retirement, and perhaps the most obvious, 4) challenge the integrity of prices and compromise the duty to the retail investor. Here was my work from roughly three years ago now:
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I remain optimistic, but it may be all a little too late. What I think we needed, at least in part, was the media to roll out the sentiment behind Value Trap as perhaps a cautionary tale of what could happen in the markets if we continued down the same path, but that never materialized. To my continued disappointment, the media kept promoting price-agnostic trading via indexing and quants, seemingly to no end.
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With the ability to stop it before it started now behind us, in my view, enterprise valuation and a focus on net cash and future expected free cash flow within companies with strong competitive advantages that are tied to secular growth trends is still the best way to combat this type of environment. But investors need to keep their guard up. We could be headed for some crazy market action in the coming months.
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Quite simply, the market has all the potential to go absolutely bonkers, and that's part of the reason why we've taken a more conservative stance in the simulated newsletter portfolios, raising the cash weightings. We want to have some "dry powder" and be ready to pick up some exciting companies at bargain prices if things get completely out of whack. This is definitely a time to be an active investor, in my view.
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With a long-enough time horizon, erratic prices will eventually converge to a fair estimate of their intrinsic value via public-to-private arbitrage, but the price-discovery mechanism of markets, themselves--that which index investors heavily rely on for their thesis--may continue to weaken substantially, if not break down, as price-agnostic trading continues to grow. I'm writing today to warn you again about what to expect.
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All told, this week has been one filled with hope and disappointment. I'll be signing off for the weekend, but you can always reach us at info@valuentum.com.
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Yours sincerely,
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Brian Nelson, CFA
President, Investment Research
Valuentum Securities, Inc.
brian@valuentum.com

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Brian Nelson doesn't own any of the securities mentioned in this article. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

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