Greater Fool Theory (In 1 Simple Chart)

Authored by SG Value Investor via ValueWalk.com,

What is the Greater Fool Theory?

The Greater Fool Theory is when the price of a good is not determined by its intrinsic value, but rather by irrational beliefs and expectations of market participants. Essentially, it is about buying a good at a price then offloading it to the next fool at a higher price. This vicious cycle would continue till the point where market participants ‘wake up’ and realize that the good is no longer worth that value. The best example would probably be the tulip mania where the Dutch were trading houses and lands just for plots of tulips. As absurd as it may sound, back then even the most rational were engaged in such madness. With such irrational beliefs and expectations of the market, it would ultimately result in a ‘bubble’.

You only find out who is swimming naked when the tide goes out

– Jimmy Buffett

What does it mean for investors?

Companies with solid earnings and fundamentals trading at higher valuations are justifiable. However, not all companies that are trading at such high valuations have the same fundamentals backing it. Companies belonging to the latter category can be further divided into three sub-categories.

 Firstly, it would be those that lack the fundamentals and earnings. These companies are constantly raising additional capital from the market, where management attempts to keep the sinking boat afloat. Companies that fall under such a scenario are trading at high valuations due to investors buying the turnaround story. If  successful, one can expect huge capital gains. On the flip side, one could lose everything too.

Secondly, it would be those that are experiencing a huge growth in earnings due to reasons such as having tapped into an emerging market like China or India. Such companies would definitely have the earnings and fundamentals to support a higher PERs and EV/EBITDAthan normal. However, the crux is what is normal? Where do we draw the line? Given how each individual investor has a different definition of fairly valued, it would just be a case of buy high, sell higher. Many a times, the run up in valuations would no longer be in tandem to the growth of the company, commonly known as a ‘false dawn’.

Lastly, it would be a scenario where the company reported great news. Investors would begin forming lofty expectations. Years ago in Singapore, there was this craze over companies having managed to enter the Myanmar market. The key here would be ‘having managed’. Whether it would truly translate to tangible benefits for the company is still an unknown. When the news reported that two of NeraTel’s clients managed to enter the Myanmar market, many investors started forming expectations that NeraTel would be able to benefit from this. The share price shot up by approximately 31.7% within a few days but came back down subsequently. Hence, as the old saying goes, ‘The greater the expectations, the greater the disappointment’.

Conclusion

With investing, there is no shortcut. Do your due diligence for every stock, and do not base your buy/sell call on someone else’s advice. When it comes to processing news, analyse it rationally and do not let your imagination get ahead itself. Last but not least, be objective. There are many great companies out there. However, we have to constantly question ourselves if the valuations are justified or whether it is a case of a buy high, sell higher, otherwise known as the Greater Fool Theory.

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