delanceyplace.com 2/2/10 - uncritical investors and dumb ideas

In today's excerpt - George Soros, one of the world's wealthiest and most successful investors, made his early fortune by betting on the stock market's irrationality in a world that had long believed in a rational and efficient market. Investors fell in love with conglomerates such as LTV Corporation in the 1960s, and that love translated into unwarranted high valuations for these companies and soaring stock prices. For Soros that was a golden opportunity:

"Soros's practical experience as a broker and research analyst convinced him that the normal market state was, in fact disequilibrium. ... As an investor, however, he finds it more useful than an assumption of market rationality, because it is a better pointer to profit opportunities. [One] of his early investment successes [was] crucial to the evolution of his thinking.

"[It] was related to the conglomerate movement in the second half of the 1960s. The flurry of company takeovers, Soros saw, merely exploited investors' tendency to rate companies by trends in earnings per share (EPS). Start with modestly sized Company A, and engineer a debt-financed acquisition of B, a much larger, stodgy company with stagnant revenues, a modest EPS, and a low market price. Merge B into A, and retire B's stock, and the resulting combined A/B will have a much higher debt load, but a much smaller stock base. So long as B's earnings more than cover the new debt service, the combined A/B will show a huge jump in per-share revenues and earnings. Uncritical investors then push up A/B's stock price, which helps finance new acquisitions. Jim Ling was one of the early exploiters of the strategy, parlaying a modest Dallas electronics company into a sprawling giant (LTV) with dozens of companies, spanning everything from steel to avionics, meatpacking, and golf balls.

"Business schools justified the scam by theorizing that conglomerates deserved higher share prices because their diversified business mix would deliver smoother and steadier earnings. It was the kind of dumb idea that underscores the disconnect between business schools and real business. If shareholders want earnings diversification, of course, they can quickly and easily diversify stock portfolios in the market. Big conglomerates, in fact, probably warrant lower stock prices. They're hard to manage, are often run by financial operators, and usually carry outsized debt loads.

"Soros understood that the conglomerate game made no sense, but he also recognized its strong following among market professionals. 'I respect the herd,' he told me, not because it's right, but because 'it's like the ocean.' Even the stupidest idea may warrant investment, in other words, if it has a grip on the market's imagination. So Soros invested heavily in conglomerates, riding up the stock curve until he sensed it was nearing a top. Then he took his winnings and switched to the short side, enjoying a second huge payday on the way down."


author:

Charles R. Morris

title:

The Sages: Warren Buffett, George Soros, Paul Volker, and the Maelstom of Markets

publisher:

Public Affairs a member of the Perseus Books Group

date:

Copyright 2009 by Charles R. Morris

pages:

10-11
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