Investing and the Keynesian beauty contest problem

When reflecting on the past year, one notable takeaway for the AIM investment team is to continue to stay focused on business fundamentals rather than attempting to profit from the narrative that’s driving the market.

This may sound simple on paper but resisting the temptation to fall into this ‘narrative fallacy’ is difficult to achieve in practice – so much so that many investors fall for this fallacy without being aware of it.

The reason is deceptively simple – by definition, the vast bulk of daily news we all consume has almost nothing to do with the fundamental drivers of long-term value. Instead, daily news flow shapes the short-term expectations that drive the dominant ‘narrative’ in markets.

What is a Keynesian beauty contest?

To explain why we believe it is critical for investors to differentiate between fundamentals and narrative, we turn to John Maynard Keynes. Though primarily remembered as an economist, Keynes managed the King’s College endowment at Cambridge from 1921 to 1946 with great success, delivering a tenfold return over a period where UK markets were essentially flat.

 In The General Theory of Employment, Interest and Money, Keynes addressed. the impact of market expectations on prices:

 The actual, private object of the most skilled investment today is 'to beat the gun'; […] to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.

 [This] may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.

 It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

 A puzzle

There have been some fascinating real-world tests that explore this mindset. The Financial Times posed the following question to its readers in 2015:

Guess a number from 0 to 100, with the goal of making your guess as close as possible to two-thirds of the average guess of all those participating in the contest.

Suppose there are three participants who guessed 40, 60 and 80. In this case, the average guess would be 60, two-thirds of which is 40, meaning the person who guessed 40 would win.

In theory, a large group of people guessing a random number between 0 and 100 will eventually average out to 50. However, a ‘first-degree’ thinker would likely reach that conclusion, and then guess 33 (equal to two-thirds of 50). A ‘second-degree’ thinker might conclude that there will be enough first-degree thinkers to move the average guess closer to 33, so the ‘smart’ guess would be 22 (two-thirds of 33). The ‘third-degree’ thinker would guess 15 (two-thirds of 22), the ‘fourth-degree’ would guess 10 (two-thirds of 15), and so on. (In reality, the average guess in the Financial Times puzzle was 17.3, meaning the ‘correct’ guess was 12).

When carried to its logical conclusion, it becomes obvious that the problem inherent in such a game is circular referencing. Each participant’s guess alters the outcome, meaning contestants end up trying to guess what the other players might be guessing, and adjust their own guess accordingly. This concept has come to be known as the Keynesian beauty contest.

Focus on fundamentals

This analogy describes a market where the participants stop paying attention to the fundamentals of an asset but instead attempt to speculate the price other people might pay for the asset at some point in future. Under such conditions, the best ‘narrative’ attracts the most investor interest. Sure, as night follows day, inflows follow interest, pushing up prices as new buyers enter the market. Combined with some good, old-fashioned fear of missing out on easy, quick returns (the result of a collection of behavioural biases hardwired into our psychology), this dynamic can lead to a dramatic disconnection between prices and the underlying economic value of an asset as more investors crowd in.

This ‘narrative’, however, is essentially just the consensus opinion constructed from the collective psyche of market participants. When the consensus narrative changes for an asset that has divorced from underlying fundamentals, the outcome for investors is usually permanent and material loss – particularly when huge amounts of borrowed money have been involved in bidding up the price. The 2007/2008 US housing market crash (“house prices can only go up!”) that triggered the global financial crisis (GFC) is a vivid example of the implications of crowded assets, owned by leveraged speculators, undergoing a material change in narrative.

Discounted cash flow model

The AIM investment process relies on determining the intrinsic value of a business. Intrinsic value measures the value of an investment based on its cash flows. While market value tells you the price other people are willing to pay for an asset, intrinsic value shows you the investment’s value based on an analysis of its fundamentals and financials. We believe that discounting future cash flows that can be distributed to the owner of an asset is the best way to determining the intrinsic value of most investments. While there are some shortcomings, it has the advantage of anchoring our estimate of value to some sort of economic reality.

Digital assets

In recent past, there has been heightened interest in non-cash-generating assets where determining a reliable estimate of intrinsic value is nearly impossible. For example, the meteoric rally in cryptocurrencies, or the sudden interest in non-fungible tokens (NFTs) – essentially, tradable digital certificates that use blockchain technology to prove ownership and origin of digital assets. British auction house Christie’s recently sold an NFT (non-fungible token) by the South Carolina artist Beeple, for USD69.3mn – the image remains freely viewable and downloadable on the internet. These assets may be useful and even scarce over the long term, but to us the recent price action seems to exhibit all the hallmarks of a Keynesian Beauty Contest.

The behaviour has arguably spilt over to other asset classes and certain pockets of the equity market. Given that capital is essentially free, many market participants are using borrowed money to place leveraged bets on asset prices continuing to rise. We find it noteworthy that there have been several liquidity-driven ‘unwinds’ in markets this year; from publicly available information, massive amounts of leverage were involved every time. We cannot claim to know how any of this will end, but we do know that leverage combined with highly crowded market positioning rarely ends well when an unexpected external event causes forced selling.

 Cash is king

When allocating our investors’ capital, we try to understand whether the expectations embedded in the market price of the businesses we own bears at least some semblance to reality when applying a reasonable range of estimates. We try to control fundamental risks by sticking to businesses that have strong balance sheets and generate meaningful amounts of cash. (As the wisdom goes: revenue is vanity, profit is sanity, but cash is king.)

In summary, we believe that a defined and repeatable process will serve investors a lot better than trying to claim the first prize in a Keynesian beauty contest.