Small-Cap Contrarian Investing
Sep 7th, 2007 | By Christopher Hancock | Category: Macroeconomics“The human race, to which so many of my readers belong, has been playing at children’s games from the beginning, and will probably do it till the end, which is a nuisance for the few people who grow up.”
—G. K. Chesterton, The Napoleon of Notting Hill (1904)
Every morning around 8:00am, I exit the Standard Oil building in downtown Baltimore, walk to the edge of my block, insert 50 cents in the newspaper box, and I pull out one copy of the Baltimore Sun.
Not the entire stack of freshly printed papers, mind you. Only one copy, just as you and most other dedicated readers in America do.
Unless you’ve fallen on hard, rock-bottom times and hope to make a few bucks by pilfering the entire stack of papers for black-market gains, then what purpose is served by grabbing more than one newspaper?
Economists call this phenomenon the law of diminishing marginal utility. Simply put, the marginal utility (satisfaction) of a good or service decreases as the quantity of the good increases.
Said differently…
The first sip of wine is always better than the last. The more we drink, the better we feel…and the better we feel, the more we drink. But consumption, like most things, comes at a price. For the fourth glass of wine, you pay with a headache. For spending more than you make, you pay with interest.
But the gods orchestrating the strings of modern finance offer us a short-term solution. They say Mr. Consumer can punt the headache. They convince his lesser half that his voracious consumption was driven in a moment of weakness…it was an aberration, they say. No worries…you can pay us back next month.
But next month the neighbor bought a brand new Hummer. And now Sally can’t be seen in the ole ‘03 Suburban. So Mr. Consumer goes back to Mr. Banker to ask that he turn his head just one more time.
“Sure,” he says. “Why not? The 2003 Chevy Suburban is so, well, 2003.”
Mr. Consumer feels much better. Wife and banker are now both happy.
The cycle continues until our hero wakes up to find himself burdened with debt. Then the banker comes in to claim his pound of flesh.
This is the game that caters to a new American generation…an entitlement class of children playing children’s games…a generation weaned on bottle of instant gratification.
They’ve been told to expect more for less… They’ve been assured that it’s O.K. to spend more than you make…because in the end, the government will be there to brace your fall.
Unfortunately, mommy and daddy are broke. And so is Uncle Sam. But the American family keeps spending despite the fact that consumer savings rate for all of 2006 remained a negative 1%.
The 2006 figure proudly surpassed the negative 0.4% savings rate in 2005. These two years produced the most reckless lack of savings since the negative 1.5% savings rate in 1933 during the Great Depression.
So while most Americans woefully stare at double-digit APR’s as they cut another check for the minimum monthly payment, the debt continues to rise.
It won’t be long before the notion of keeping you’re financial head above water will soon require more effort than signing one’s name on the back of yet another new credit card.
But wait a second. How did we get here to begin with, you ask? If the law of diminishing marginal utility states that the satisfaction of a good or service decreases as the quantity of the good increases, why do we keep consuming more than we could ever hope to utilize?
I would venture to guess that he distance between economic theory and economic reality in most cases is somewhere between one and two feet. That’s the approximate distance from your brain to your heart.
As Bill Bonner points out in his latest book Mobs, Messiahs, and Markets, “people’s convictions arise not from proofs supplied by the brain but prejudices amplified by the heart.”
Most modern economic theory remains based on the premise that man is a rational being. Anyone who’s spent more than five minutes on planet Earth knows that man is rarely a rational being. As Bonner explains: “Human beings are neither good nor bad, they’re merely subject to influence.”
The reason seems simple. People find comfort in knowing lots of other people have made the same choices…like fans routing for a sports team. Human beings naturally gravitate towards the crowd. And “crowds cannot think. They can only feel and act.”
So their behavior only seems rational in the fact that “everybody’s doing it.” That was the rationale explained to me the first time someone offered me a cigarette.
You see, it’s time to separate yourself from the masses… It’s time to grow up. It’s time to step back from the crowd. Find a good business and determine its intrinsic value. Then simply wait for the mob to overreact or under react to news, and buy the stock when the market prices the share for less than it’s worth.
That’s basically it. So the next time you find yourself drawn to either 11 West 53rd or 117 Sandusky Street…take a step inside. Fight your way through the 150 silent, confused faces with their heads tilted slightly to the side and take a good, long hard look at that simple red dot adorned on white canvas. Remark to those in your immediate vicinity how both circle and canvas exquisitely embody the golden ratio…let them know that Leonardo da Vinci himself could not have done it any better. Then simply walk away. You know it’s time to ask for the refund.
And for the record, I don’t smoke.
Until next time,
Christopher Hancock
September 7, 2007
P.S.: Because of this groupthink principle, I look for many offshore investments that aren’t going to find themselves on the front of Wall Street Journal. And believe me, the readers of my newsletter, Free Market Investor, aren’t complaining.
