Is the Stock Market Really Just a Beauty Contest?


Last week, Pulitzer Prize-winning author Ron Suskind came by the office to give a talk. In one of his remarks, he referenced the idea of a Keynesian beauty contest. It was a reference to a quote from John Maynard Keynes in his book The General Theory of Employment, Interest and Money. Here it is, in most of its glory.

[P]rofessional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs ... 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.

While Keynes is referring to professional investors in the early 1900s, in modern-day times, with a wealth of investing information just a click away, the metaphor is applicable to investors in general. In other words, we're no longer investing in the best companies, and we're not even investing in the companies that we think everyone else likes -- we're investing in the companies that we think everyone else thinks are the companies that everyone else likes. And yet people wonder if we're done with financial bubbles.

Two examples
I want to look at three examples of this in action. Before we get into the specifics, let me highlight that being the subject of a rumor or a wave of sentiment doesn't mean that the company isn't worth investing in. All it means is that the price of that company's stock is being moved by rumors or waves of sentiment. Lots of good companies swing wildly on this sort of speculation, and for the long-term investor, those swings are almost meaningless.

With that caveat, let's look at Deckers Outdoor first. On Friday last week, the stock jumped 7.5% on news that other people thought good things might be about to happen. The reasoning is as convoluted as the sentence explaining it. There were no new press releases, no earnings, no announcements of any sort. No major competitor had announced earnings that might have drawn the stock up. And yet the stock went up.

This is where the beauty contest comes into play. Deckers seemingly jumped due to investors thinking that other investors thought investors would buy the stock. Whether that was spelled out with references to resistance levels or "wedge patterns," it ignored fundamental issues that long-term investors should care deeply about.

It ignores sales, which declined 9% last quarter. It ignores margins, which have been devastated by raw material costs over the past year. It ignores consumers, who have moved away from the brand and toward new shoe styles, by competitors like Skechers , which has seen a huge jump in sales and income over the last year now that its legal worries are behind it. But instead of looking at the 1 percentage point increase in gross margin at Skechers and wondering how that reflects on Deckers, investors are just blindly jumping on the Deckers wagon since everyone else seems to be doing it, too.

In a similar vein, Bed Bath & Beyond took a hit yesterday because "some guy said so." That guy happens to be a Goldman Sachs analyst, but who cares? That analysis didn't change what was happening at the retailer. It didn't make the 15% revenue growth from last quarter smaller. It didn't decrease the company's 2% comparable sales growth. All it did was say that the company seems to be having a hard time online, which means that they might be losing market share.

That's not a new reason to sell. That's just an obvious fact. Again, the market chased its own tail, trying to figure out what that other investor's statement would mean for other investors, and then what that would mean the best thing to do was. Forget the sales growth, forget the existing market share, just do what it seems like other people might think other people might do.

Rising above the noise
The bottom line is this: Ignore noise, bumps, and other investors and do what you think is right. Do you think that Deckers got better on Friday? Was there new news that really made the company more efficient or a better long-term play? If not, don't buy into the hype. By ignoring all the background noise, we can invest in better companies and be better positioned for the long run. Do you think the next billionaire investor is really sitting out there thinking, "Well, an analyst at Goldman hates it, so I'm selling!" Of course not. If you vote for the third-order pretty face, the one that you think others think will be the one that others like, you not only don't end up with the prettiest face, you probably end up with a wallaby.

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Fool contributor Andrew Marder has no position in any stocks mentioned. The Motley Fool recommends Bed Bath & Beyond and Goldman Sachs. The Motley Fool owns shares of Skechers. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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