Published On: July 21, 2020
Written by: Ben Atwater and Matt Malick
Today, we continue our series on Behavioral Finance. Behavioral finance is the crossroads of psychology and economics. It recognizes that investors are not always rational, have limits to their self-control and have biases that influence their decision-making. In prior emails, we have covered self-serving bias, overconfidence, hindsight bias and confirmation bias. In this essay, we turn our attention to herding mentality.
Herding mentality, or simply herding, occurs when we make decisions based on a perception of what other investors are doing rather than any underlying security analysis. Herding is extremely prevalent in our current environment. The combination of ultra-low interest rates, a COVID-damaged economy and unsightly fundamentals is causing investors to buy stories about the future rather than buying fundamentals.
Arguably, herding mentality fuels every asset bubble in history, from the Dutch tulip bulb mania of the 1600s to the U.S. housing bubble culminating in 2008. As investors flock to a certain investment idea, a desire to make a quick buck combines with an intense fear of missing out.
Few of us identify bubbles until after they have popped because bubbles tend to inflate for a very long time. While the bubble is expanding, doubters look foolish while believers create narratives to justify ever higher prices. But the bubble inevitably does pop and those who joined the herd, most of whom arrive late, end up with major losses.
For many years now, the technology sector, led by a handful of mega tech stocks, has been the primary driver of market gains. Even during the COVID-induced crash earlier this year, the tech sector outperformed the broader market. The meteoric rise of many technology companies illustrates an undeniable herding mentality. Investors should be wary and maintain a healthy skepticism.
Shares of Tesla (TSLA), the electric vehicle manufacturer led by its enigmatic founder Elon Musk, have been on a tear, rising over 260% year-to-date. Tesla is now the world’s largest auto manufacturer by market capitalization, despite claiming less than 1% of global auto sales and never having reported a full-year profit.
Adding to the euphoria about the stock and the cult of personality around its founder, Musk recently sent a pair of Tesla-branded “short shorts” to David Einhorn, a hedge fund manager with a short position in TSLA (to “short sell” a stock is to wager its price will fall).
Tesla operates in a notoriously crowded industry, auto manufacturing, where no single company boasts greater than 8% market share. Despite Tesla claiming a lead in battery technology, other manufacturers will ultimately earn a meaningful share of the electric vehicle market as it matures. Investors are clearly succumbing to a herding mentality, bidding up shares that have become untethered from economic reality.
Elsewhere in the world of futuristic vehicles, shares in Nikola (NKLA), an aspiring electric and fuel cell truck manufacturer, began trading publicly on June 3rd and spiked over 115% within a week. Nikola’s market capitalization briefly exceeded that of Ford (F). Shares have retreated since June but Nikola’s market capitalization still stands at a ridiculous $13 billion.
NKLA investors seem undeterred by the company’s 2019 revenue of just $115,000, its operating losses of $88 million or that it hasn’t produced anything more than some vehicle drawings and a claim of more than $14 billion in “preorders,” most of which buyers could secure online without a down payment. Because there is no underlying profit, cash flow, sales or even a finished product to justify the current valuation, investors are buying NKLA based solely on the hope it becomes the Tesla of trucks.
On July 6th, shares in the ride sharing company Uber (UBER) rose about 6% on news that Uber was purchasing Postmates, a food delivery company, in an all-stock deal for $2.65 billion. Since its March 18th low, Uber stock has risen 120%. UBER went public in May of 2019 and the company has never reported a quarterly profit in its history. Similarly, Postmates, which boasts just an 8% share of the American food delivery market, has also never reported a quarterly profit.
Investors are bidding up the share price of Uber, which makes no money, while Uber dilutes their shares to purchase a small food delivery company that also makes no money. Excitement about food delivery, which is expanding rapidly due to the pandemic, trumps the simple fact that transporting someone’s dinner (or people themselves) by car is unlikely to ever earn outsized profits, if any profits.
Finally, an example from the semiconductor industry. Shares in chipmaker Nvidia (NVDA) have risen almost 2,000% over the last five years, including a 75% year-to-date gain, on optimism that Nvidia can sell its graphics processors for use in datacenter servers and artificial intelligence. Recently, NVDA briefly surpassed Intel (INTC) to become the third largest semiconductor manufacturer in the world with a market capitalization that now stands at $253 billion.
Nvidia’s relatively minor inroads in the server chip business and dreams about artificial intelligence have driven the stock to eye-watering heights, despite Nvidia’s server chip business generating just $3 billion in annual revenue to Intel’s $20 billion. NVID shares change hands at 76 times earnings to INTC’s 11 times even though Intel’s trailing annual earnings per share have risen 78% over the past three years to Nvidia’s 34% increase. By market capitalization, Intel dropped to the fourth largest semiconductor company, but its profits are 40% greater than its three largest market capitalization competitors, Nvidia included, combined.
Arguably, the technology heavy Nasdaq stock index itself reflects a herding mentality among investors who see continued gains with what they perceive to be limited risk. The narrative today is simple – COVID will not harm tech stocks and the price of tech stocks does not matter because future growth prospects are infinite. Therefore, you get outsized return, no risk and no worries about COVID-19.
Investors who buy based solely on the expectation that other members of the herd will pay a higher price tomorrow do so at their peril. As Charles MacKay said in Extraordinary Delusions & the Madness of Crowds, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”
When investors come to their senses on story stocks, and the herd stops buying, prices can fall rapidly. Even when earnings and cash flow are sufficient to support stock prices, stocks can still fall far and fast. However, when a company has limited free cash flow and sparse earnings to support a lofty price, the damage can be truly severe. It is our view that investors should always contemplate investment versus speculation and remember the fable of the tortoise and the hare.