After I recently lamented the strong performance of Exxon (XOM) stock despite the price of oil being in the $40 range and the necessity for the oil giant to take large write-downs, I speculated that the rise of indexing strategies in the stock market means that people will be sending through automatic buy orders without much regard for whether the fundamentals of the business deserve increased demand for the stock.
A reader forwarded me an on-point discussion of this topic between a young Bill Ackman and Charlie Munger that took place as part of “The Buffett Essays Symposium” in 1996.
Ackman offered the following question/observation to Berkshire Vice Chair Charlie Munger: “We’ve heard a lot of discussion about how institutions and individuals use index funds. But to the extent that more and more capital becomes indexed—and if you think about index fund managers as really being a computer, then in terms of the voting shares for instance—the more stock that is held by people who don’t care about individual corporations, the more there is a significant societal detriment to have capital in the hands of people who are just seeking average performance. The result is that the more capital that is indexed, the more it inflates the prices of companies in the S&P and leads to poor capital allocation and maybe detrimental owner performance over time because some companies get more capital than they deserve.”
Munger responded: “You are plainly right. If you pushed indexation to the very logical extremes, you would get preposterous results.”
To fix this, you will need some type of countervailing force to execute a two-step process.
First, you will need a large entity with capital—something like a billion-dollar hedge fund—to put pressure on an index component by shorting the stock. This process may take months because when you borrow shares to sell short, you induce a price drop by increasing the volume of shares for sale.
This effort will be most effective if coordinated with media awareness of an issue that causes the active investors to sell the stock. It is a common myth to believe that a $100 stock must trade at $99.99, $99.98, and so on before reaching $50. That is not required it all—it is the mutual assent of any bid with any ask price that triggers the sale of a stock. If news becomes publicly available that signals extreme overvaluation, the quick abandonment of the stock can cause its price to fall quickly and then lead the stock to become a less meaningful part of the market-cap weighted index or removed altogether.
The second step of the process is that you will need a private equity takeover that is aimed at improving the management of the company. Ackman’s premise is that index fund managers like Vanguard, State Street, and Blackrock won’t agitate for superior returns of Index Component #232 in the same way that an individual shareholder with 20% of his net wealth in the stock will. The absence of this pressure, in Ackman’s view as well as my own, will lead to complacency with mid-single digit returns. If a business capable of 10% annual returns instead gives returns of 6%, and it is majority owned through the Vanguard indices but is a relatively small percentage compared to Vanguard’s other indexing assets, is it going to receive significant scrutiny? Probably not.
If the world continues to gravitate towards index funds, I suspect you will see the return to glory in the private equity industry. Remember how Business Week put out that “Death of Equity” issue in the early 1970s right before the beginnings of a nearly three decade bull market? I suspect something similar is happening right now with the criticism of private equity.
If index funds cause a significant number of stocks to become inflated compared to fundamentals, and management performance suffers due to the absence of an ever-scrutinizing shareholder base that cares a lot about that particular corporation, then you are going to see private equity make a comeback—first, by shorting the overvalued shares, and then, by purchasing the stock after it is de-indexed at a lower price and reaping the gains that come from improved performance. Then, the private equity investors will sell out as the stock gets re-indexed and rises automatically, planting the seeds for the problem to begin anew.
The alternative is that a recession causes people to pull out of stocks, and you see mass indexing in reverse on the sell side where people stop making automatic purchasers and indiscriminately sell their stake in all of the S&P 500 components.
Either way, the results should be interesting as an increasing pool of investors continue to make investment decisions that are not the direct result of an analysis of the individual security. In the 20th century, people didn’t have enough information to make investment decisions. In the 21st century, we have nearly all the information but yet we willingly hijack our processing to make automatic decisions rather than fact-specific ones. If you take it as a first principle that fundamentals always win, you should view this all with bemusement because the investing collective is increasingly choosing to abandon competition with you in the valuation of securities.