I’m going to present you with a theory—my personal theory—on how the stock market works.
If you’re not a very experienced investor, that’s ok. I have a gift for simplifying things, or so I am told. I am not going to blind you with science or baffle you with B.S.
My hope is that at the end of this article, you will have a better understanding of how the stock market works.
Keep in mind that this is just a theory. If I had the math chops I suppose it could be testable.
There is such a thing as vice stocks—tobacco companies, gun companies, things like that. If you buy shares of a tobacco company you are financially supporting that tobacco company by lowering their cost of capital.
You’re also generally contributing to the aggregate level of misery in the world, considering that smoking contributes to 700,000 deaths in the US annually.
The good news—if you invested in these tobacco stocks at any point over the last 20 years, you have handily outperformed the market.
Isn’t that weird? It is especially weird because of the rise of socially responsible investing in the last decade, where you have folks who refuse to invest in tobacco stocks or gun stocks.
You would think that fewer people buying tobacco stocks and gun stocks would cause them to go down, or at least, not go up as much.
Plus, the whole theory of socially responsible investing is that do-gooder companies will have better stock market performance.
But that is not how it works!
This is how it works.
The Theory of Constraints
Take two portfolio managers: A and B.
Portfolio manager A is a socially responsible investor. He won’t invest in tobacco, alcohol, or gun stocks.
Portfolio manager B can invest in whatever the hell he wants!
So here is the key point: If portfolio manager A has constraints on what he invests in, and portfolio manager B doesn’t, how can you expect portfolio manager A to outperform portfolio manager B?
You can’t. And that’s really why socially responsible investing has been a complete disaster (though people still try, and it is bigger than ever).
There is even a mutual fund, USA Mutuals, that invests in the vice stocks. For a while, it was killing it. And AdvisorShares has a Vice ETF.
Now, here is the really interesting part of the idea.
With socially responsible investing, portfolio managers have explicit constraints on what stocks they can buy.
Can you think of situations where there are implicit constraints on what stocks people can buy?
What kind of stocks do people not like to buy? Well, “bad” stocks. But what constitutes a bad stock?
I don’t mean bad in the sense that the company does bad things. I just mean a “bad” stock that is embarrassing to own.
When are stocks embarrassing to own? Usually, they are embarrassing because they went down a lot. This is often accompanied by gross mismanagement of the company’s fortunes.
Let me give you an example or two.
Chipotle (CMG) was an embarrassing stock last year.
A company that prided itself on organic ingredients had a food safety crisis, management seemed more interested in things like serving dessert. And then Bill Ackman (who was ice cold at the time) got involved.
Remember, when institutional investors own a stock, everyone knows about it. They file something called a 13F which contains all of their holdings. They do this once a quarter. Oftentimes a portfolio manager will get rid of an embarrassing stock before the filing date so nobody will see it in his portfolio.
CMG was widely considered to be an embarrassing stock. That’s an implicit constraint—the “save face” constraint.
People refuse to buy the stock, not because it is a vice stock, but because it is an embarrassing stock. There are some stocks you just can’t be seen holding.
You can’t expect a portfolio manager with constraints to outperform the one without constraints.
In this case, a portfolio manager is constrained to not buy Chipotle or any other embarrassing stocks. The unconstrained portfolio manager can buy Chipotle and other embarrassing stocks.
Of course, Chipotle leapt more than 100% since then…
Some people would say that this is just value investing. Not really! There are plenty of value stocks that are not embarrassing to own.
I’m talking about stocks that you would get ridiculed for buying. You don’t have to spend much time on Twitter to find out which ones.
This is pretty groundbreaking stuff.
If you think about it, you can model the entire stock market in terms of constraints.
Portfolio Manager A has constraint 1, constraint 2, and constraint 3.
Portfolio Manager B has constraint 3, constraint 4, and constraint 5.
Portfolio Manager C has constraint 3, constraint 5, and constraint 6.
Of course, constraints aren’t all about embarrassment.
A value manager won’t invest in growth stocks.
A growth manager won’t invest in value stocks.
A small cap manager won’t invest in midcap or large cap stocks.
In fact, there are very few portfolios out there whose mandate is to be completely unconstrained.
This is also true with bonds. Interestingly, there are managers whose mandate it is to buy the embarrassing bonds—they’re called distressed investors. Nothing like that really exists for equities, which is strange.
What about as an individual investor? Well, you can do an analysis where you find the stock subject to the most constraints and the stock subject to the least constraints, and buy the former and short the latter.
I’m sure it’s just a bunch of linear algebra. Like I said, if I could do the math, I would publish this in a heartbeat.
This isn’t a mathematical justification for value investing. This is a mathematical justification for contrarian investing.
Really, it provides the intellectual rigor for what I have been trying to accomplish my entire professional career as a contrarian investor.
Everything has to be owned by someone. So if you’re not operating under the constraint of embarrassment, then it stands to reason that you can get in at a lower price.