Unique insight or common knowledge?

Posted by TEBI on October 16, 2020

Unique insight or common knowledge?

 

 

Something that everyone knows isn’t worth knowing.

 — Bernard Baruch

 

 

This tale is part of LARRY SWEDROE’s Tales to Enrich Your Future series. Like all the tales, unless otherwise specified, they are hypothetical examples designed to educate the reader on investment principles. 

 

It was the new millennium, and Debbie was thrilled to hear that Harry Dent was coming to town to give a lecture at the local high school. Her reason: she worked for the U.S. Census Bureau, and Harry Dent was a famous demographer. Dent was going to give a speech based on his book The Roaring 2000s Investor: Strategies for the Life You Want.

Debbie was eager to learn how she could use her knowledge of demographics to help her pick stocks that were sure to deliver great returns. After all, she knew that demographics is a science and Dent was highly regarded. She figured his books must be bestsellers for good reason. And she had heard that millions of investors were now investing the “Harry Dent way”. She wanted to get in on a good thing by learning how to apply her knowledge of demographics to the world of investing.

 

Impeccable logic

At the seminar Debbie listened carefully and took copious notes to make sure she captured all of Harry Dent’s insights. By the end of the talk, Debbie was so excited she could hardly contain herself.  Not only was Dent a great speaker, he had also laid out a clear road map for investment success. Everything Dent said made great sense to her. The logic was impeccable.

Upon arriving home, she organised her notes to make sure she clearly understood the major investment themes Dent had introduced. She was able to narrow them down to the following:

• The population of the United States is rapidly ageing.

• An ageing population will boost the demand for certain products and services benefiting those sectors (i.e., healthcare and pharmaceuticals).

• Individuals can benefit from these trends by investing in stocks of companies in those sectors of the economy.

 

Time to be bold?

While normally a cautious investor, Debbie decided now was the time to be bold. The next day she would call her broker and place an order to buy the stocks of several of the leading pharmaceutical companies as well as the stocks of a variety of companies that participated in the healthcare sector. She was so excited that she wanted to share what she had learned with Mona, her best friend.

Debbie told Mona about her plan. Fortunately for Debbie, Mona was sceptical. Something just didn’t sound right.

 

Let’s think this through

Mona: Debbie, that all sounds logical, but it also sounds too easy. Before you rush to invest your life savings based on this strategy, let’s think this through. I don’t know much about the stock market, so help me out here. Debbie, tell me, who does most of the trading in the stock market and therefore sets the prices of stocks?

Debbie: That’s easy. It’s not individual investors like you and me. Instead, it’s the big institutional investors.

Mona: Who are they?

Debbie: They’re pension plans, mutual funds and hedge funds.

Mona: Are the people who make the investment decisions on behalf of those institutions intelligent?

Debbie: Of course they are. They know what they’re doing or they wouldn’t be managing billions of dollars.

Mona: That makes sense to me. Now, do you think it’s likely even a single one of these smart institutional fund managers is unaware that the population of the United States is getting older?

Debbie: Of course not.

Mona: Okay. Now let’s take that one step further. Since they know the population is ageing, do you think it’s possible these smart investors are unaware that the demand for healthcare is going to rise rapidly?

Debbie: Of course not.

Mona: And if the demand for healthcare is going to rise rapidly, do you think these same smart investors are unable to figure out that the profits of companies in the healthcare sector are also likely to rise rapidly?

Debbie: Of course not. They know it. But what’s your point?

Mona: My point is this: If they know this, isn’t it logical that the prices of the stocks of the companies you are ready to rush out and buy already reflect those great expectations?

Debbie: I guess so.

Mona: And if the companies are so likely to achieve great earnings, doesn’t that make them safe investments?

Debbie: Sure, but that’s the point. I can get great returns without taking lots of risk.

Mona: Debbie, that can’t be. I don’t know much about investing, but I’ve always heard that risk and expected return are related. Thus, if these investments are as safe as you say they are and the current prices reflect great expectations, how can you expect to get high returns? Don’t you have to take lots of risk if you want to earn high returns?

 

How unique was Debbie’s insight? 

Debbie was deflated. Mona’s line of thinking made so much sense that she was embarrassed she hadn’t thought of it herself. How could she have been so wrong?

She thanked Mona for her insights and decided to sleep on it. First thing in the morning, she ran out to get a copy of the Wall Street Journal. She immediately opened the paper to the section that showed the closing stock prices of the prior day. She wanted to see how the market was pricing some of the companies in which she had planned to invest relative to how the rest of the stocks were priced. She first noted that the price-to-earnings (P/E) ratio of the S&P 500 was a bit less than 19.

The first stock on Debbie’s list was Pfizer, the leading pharmaceutical company. She was disappointed to learn that it was trading at a P/E of 30, almost 60 percent more expensive than the market.

She then checked the price of the other pharmaceutical company she had planned to buy, Eli Lilly & Company. She found that its P/E ratio was over 26, about 40 percent richer than the market.

Next on the list was Roche Holding, a large international pharmaceutical company. She found that it was trading at a P/E of over 36, almost double that of the market. This was getting discouraging. It sure looked like Mona was right.

She decided to check the price of one more stock, Genentech, the leading biotechnology company. It was trading at a P/E of 70, 268 percent richer than the market. That was enough. She called Mona to tell her what she had found and to thank her for preventing a terrible mistake.

 

The moral of the tale

What Debbie learned was that Harry Dent had made the mistake of confusing information with knowledge you could use to generate above-market returns. What she thought was unique insight was actually common knowledge. A rapidly growing population, leading to rapid growth in demand for healthcare products and services and in turn a rapid growth in profits for providers of such products and services, was nothing more than information. It conveyed no knowledge she could use to beat the market.

There is another lesson that Debbie needed to learn about trying to benefit from such obvious trends. Mona could have also told Debbie that even if she knew with 100 percent certainty that the demand for a certain product or service would rapidly rise, that information tells her little, if anything, about future profits in the industry. The reason is that competition can lead to increased supply that is more than sufficient to meet demand.

 

LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
Want to read more of Larry’s insights? Here are his most recent articles published on TEBI:

What investors can learn from Moneyball

When even the best are unlikely to win

Sport, investing and the paradox of skill

The names are never the same

A strategic approach to rebalancing

The cost of anticipating corrections

A cautionary tale about chasing performance

Markets are more efficient than you think

 

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