A special emergency edition of Money Stuff.
Matt Levine
Bloomberg, June 12, 2020
I have occasionally spotlighted the newsletter / commentary written by my Bloomberg Opinion colleague Matt Levine (See, e.g, this, this, this, or this). He is always thought provoking, but I found this post to be so well thought out, well-written, and timely, that rather than merely link, I would share it. This is from last week. Please subscribe at this link.
One theory is that the stock market is a way for people to invest money in companies. Companies want to raise money to do stuff, so they offer partial ownership of themselves to investors in exchange for money. The companies have projects that they want to fund, the investors want to fund projects, and the stock market is a way of allocating the most money to the best projects.
In its simplest form this theory is not especially true. Most public companies do not fund themselves by selling stock; mostly they fund themselves internally, or with debt, and the main thing that they do with their stock is buy it back. If you buy stock, you are buying it from someone else, who bought it from someone else, who bought it from someone else; way back in the distant past someone bought it from the company, but what does that have to do with you?
Still some version of this theory is probably right. The stock market works as if people were investing money in companies; some indirect mechanism ties the secondary trading of stock to the allocation of capital. 1 And of course in the limit companies can raise money by selling stock. So buying stock is like investing money in a company in exchange for partial ownership of its projects, and the amount you should pay for a stock is basically the discounted present value of the company’s cash flows from its business. The mechanisms of the market tie the price of the stock to the underlying value of the company.
But there is another theory. This theory is that the stock market is a fun casino, and you should buy stocks because they will go up and down in exciting fashion and might make you rich quick. This is a very old theory, and I suspect that for much of the history of financial markets it was considerably more popular and better supported than the discounted-present-value-of-cash-flows thing. A modern variant is the Dave Portnoy Stocks Theory:
Dave Portnoy, founder of the popular website Barstool Sports, has turned to day trading, sharing regular proclamations to his 1.5 million Twitter followers as he scans his portfolio.
“Stocks only go up, this is the easiest game I’ve been part of!” he said in a video on June 4, with Dire Straits tunes in the background. …
“It took me a while to figure out that the stock market isn’t connected to the economy,” he said. “I tell people there are two rules to investing: Stocks only go up, and if you have any problems, see rule No. 1.”
I do not exactly want to endorse this theory. Not because it isn’t true—well, the “stocks only go up” part obviously isn’t, but “the stock market is a fun casino” may be true depending on your view of fun—but because it doesn’t really have any content. “Buy stocks, it’s fun,” doesn’t tell you which stocks to buy, or how much to pay for them. Without a rigorous quantitative model of fun, this theory makes no useful predictions.
Still it is extremely popular, and we have talked about it a lot recently. I call it, or something like it, the “boredom markets hypothesis”: People got bored in their coronavirus-related lockdowns, and they couldn’t bet on sports because sports were canceled, so they turned to betting on stocks as a form of entertainment, not investment or financial analysis. The stock market is a casino that happens to still be open.
Again, without a rigorous quantitative model of fun, this theory does not produce a well defined value for any stock; it doesn’t tell you precisely how much you should pay for a stock in order to have fun. 2 Still the imprecise subjective values it produces should, at least sometimes, be different from those produced by normal, boring, finance-y theories about owning companies’ cash flows. Some (most?) companies are exactly as fun as their cash flows; if you want a sound investment, you should pay $X for them, and if you want to have a good time you should also pay $X for them. (Because their cash flows will pay for an amount of fun with a present value of $X, etc.) Other companies are less fun than their cash flows, and you should demand a discount to invest in them. And some companies are much more fun than their cash flows, and people will buy their stock for entertainment without worrying too much about conventional valuation.
Naturally if you are a smart boring finance-y person trying to make money, and you own those stocks, you should sell them to the fun people, because they will overpay you for them. You can sell a $100 cash flow for $200 because someone else likes a good story and a crazy gamble. 3>
There is some limit to this: Eventually, all the boring finance people will sell their stock to fun people, so only the fun people will own the stock, so there’ll be no one left to do this trade. Tesla Inc. is the paradigmatic fun stock: It is run by a cartoony billionaire who sends rockets into space and messes around with flamethrowers, it has a huge and volatile valuation that often seems disconnected from its financial results, it is beloved by message-board day-traders. It is also regularly one of the most shorted stocks in the market. One way to interpret that is that people who care about valuation sold all their stock to people who love fun, and then had to go and borrow more stock to sell to the fun people because the demand for fun was so insatiable. 4
But you know who has a lot of stock to sell? Companies. Companies can just print more of their own shares. It is not usual, exactly, because most big public companies do not mostly fund themselves by selling stock. But it is the deep background fact of the stock market, the thing that allows it all to work: The point of stock trading, in some vague notional sense, is that it allows companies to raise money by selling partial ownership of themselves.
And so when Tesla was the most shorted stock in America as its stock was soaring and fun, Tesla quite sensibly decided to sell $2 billion worth of stock. If you are that desperate to buy Tesla stock, sure, Tesla will sell you some. Better for Tesla to take your money than a short seller. Tesla at least can use it to make Teslas.
It is … an arbitrage? A synergy? A beautiful trade in which everyone is made better off? Cheating? A company wants money to fund its projects. Investors want a fun gamble that will amuse their friends on Reddit. The company has projects that are worth $X. Investors will pay $2X for fun. The company taps cheap financing. The investors have fun. Everyone wins.
But there are rumblings of complaint. It’s fine for other investors to sell their overpriced stock to people who want fun, but it is a little unseemly when the company does it. The company has fiduciary duties to its shareholders; selling them stock for more than it’s worth seems wrong. One defense is, how can anyone know how much the stock is “really” worth? This stuff about cash flows sounds scientific but isn’t; no one really knows what the company’s future cash flows will be, and if the investors are optimistic you can’t prove that they’re wrong. Another defense is, well, it’s worth that much to them, since they get pleasure out of gambling. That one seems somehow inadmissible. Fiduciaries aren’t really supposed to go around enabling gambling.
_______
1.If a company has a high stock price, its employees will be pleased (they are paid in stock), and it can attract new good employees, and it can make good acquisitions (and pay for them in stock), and borrow money cheaply (lenders are reassured by the stock price), etc. Private companies that *do* need money will have an easier time raising it if similar public companies trade at high stock prices, and people thinking about starting companies will try to start the sorts of companies that might end up with high stock prices. That sort of thing.
2. I don’t know, arguably it tells you that you should pay a fun number for stocks? Like, if you are going to buy stock, it might be more fun to buy it for $420 than for $417.94. (420 is a marijuana reference.) The stock of famously fun Tesla Inc. recently hit$1,000, which is a pretty fun number I guess, but in 2018Tesla’s famously fun chief executive officer, Elon Musk, famously pretended he was going to take it private for $420 “because he had recently learned about the number’s significance in marijuana culture and thought his girlfriend ‘would find it funny, which admittedly is not a great reason to pick a price.’” BMH theorists would say, no, it’s a great reason.
3.This is obviously a very stylized story and you can never be sure that the cash flows aren’t *actually* worth $200; telling the difference is never as easy as I make it out to be in the text. And of course if this is true maybe you should buy the fun stocks so you can sell them later at a higher price, etc., none of this is investing advice.
4. Please don’t email me to be like “actually Tesla is a great financial investment,” it’s fine, we are talking in generalities here, I do not mean to comment on the actual present value of Tesla’s expected future earnings.
_____
If you’d like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks!
