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Beware the Beauty Contest

April 2021

When reflecting on the past year, one notable takeaway for the Constantia investment team is to be mindful of keeping our focus on business fundamentals rather than attempting to profit from whatever narrative is driving the market. This sounds simple enough on paper, but resisting the temptation of falling into this ‘narrative fallacy’ is quite difficult to achieve in practice – to such an extent that many investors step into this mindset without even realising it.

The reason is simple: by definition, the vast bulk of daily news we all consume has almost nothing to do with the fundamental drivers of long-term value. Instead, daily news flow shapes the short-term expectations that drive the dominant ‘narrative’ in markets.

To understand why we believe it is critical for investors to differentiate between fundamentals and narrative, we turn to John Maynard Keynes. Though primarily remembered as an economist, Keynes managed the King’s College endowment at Cambridge from 1921 to 1946 with great success, delivering a tenfold return over a period where UK markets were essentially flat.

In The General Theory of Employment, Interest and Money, Keynes addresses the impact of market expectations on prices:

The actual, private object of the most skilled investment today is 'to beat the gun'; […] to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.
[This] may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.
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. And there are some, I believe, who practise the fourth, fifth and higher degrees.

There have been some fascinating real-world tests that explore this mindset. The Financial Times posed the following question to its readers in 2015:

Guess a number from 0 to 100, with the goal of making your guess as close as possible to two-thirds of the average guess of all those participating in the contest.

Suppose there are three participants who guessed 40, 60 and 80. In this case, the average guess would be 60, two-thirds of which is 40, meaning the person who guessed 40 would win.

In theory, a large group of people guessing a random number between 0 and 100 will eventually average out to 50. However, a ‘first-degree’ thinker would likely reach that conclusion, and then guess 33 (equal to two-thirds of 50). A ‘second-degree’ thinker might conclude that there will be enough first-degree thinkers to move the average guess closer to 33, so the ‘smart’ guess would be 22 (two-thirds of 33). The ‘third-degree’ thinker would guess 15 (two-thirds of 22), the ‘fourth-degree’ would guess 10 (two-thirds of 15), and so on. (In reality, the average guess in the Financial Times puzzle was 17.3, meaning the ‘correct’ guess was 12).

Carried to its logical conclusion, it becomes obvious that the problem inherent in such a game is that there is a circular reference: each participant’s guess alters the outcome, meaning contestants end up trying to guess what the other players might be guessing, and adjust their own guess accordingly. There is no point at which one can confidently get off this train of thought in the knowledge your answer is correct. The concept has come to be known as the Keynesian Beauty Contest.

Real-world examples

This concept quite accurately describes a market where the participants stop paying attention to the fundamentals of an asset, but rather attempt to speculate about what other people might pay for the asset at some point in future. Under such conditions, the best ‘narrative’ attracts the most investor interest. Sure as night follows day, inflows follow interest, pushing up prices as new buyers enter the market. Combined with some good, old-fashioned fear of missing out on easy, quick returns (the result of a collection of behavioural biases hardwired into our psychology), this dynamic can lead to prices dramatically disconnecting from the underlying economic value of an asset as more investors crowd into it.

However, the ‘narrative’ is essentially just the consensus opinion constructed from the collective psyche of market participants. When the consensus narrative changes for an asset that has divorced from underlying fundamentals, the outcome to investors is usually a permanent and material loss – particularly when huge amounts of borrowed money have been involved in bidding up the price. The 2007/2008 US housing market crash (“house prices can only go up!”) that triggered the Global Financial Crisis is a vivid example of what can happen when crowded assets owned by leveraged speculators undergo a material change in narrative.

The Constantia investment process is based on determining the intrinsic value of a business. While market value tells you the price other people are willing to pay for an asset, intrinsic value shows you the investment’s value based on an analysis of its fundamentals and financials. We believe that discounting future cash flows that can be distributed to the owner of an asset is the best way to determining the intrinsic value of most investments. While there are some shortcomings, it has the advantage of anchoring our estimate of value to some sort of economic reality.

Digital assets

Of late, there has been an explosion of interest in non-cash-generating assets where determining a reliable estimate of intrinsic value is nearly impossible. We would point to the meteoric rally in cryptocurrencies, or the sudden interest in non-fungible tokens (NFTs) – essentially, tradable digital certificates that use blockchain technology to prove ownership and origin of digital assets – as examples. (Christie’s recently auctioned off an NFT of the work of digital artist Beeple for USD69.3mn; the image remains freely viewable and downloadable on the internet.) These assets may have utility and even scarcity over the long term, but recent price action seems to us to exhibit all the hallmarks of a Keynesian Beauty Contest.

The behaviour has arguably spilt over to other asset classes and certain pockets of the equity market. Given that capital is essentially free, many market participants are using borrowed money to place leveraged bets on asset prices continuing to rise. We find it noteworthy that there have been several liquidity-driven ‘unwinds’ in markets this year; from publicly available information, massive amounts of leverage were involved every time. We cannot claim to know how any of this will end, but we do know that leverage combined with highly crowded market positioning rarely ends well when an unexpected external event causes forced selling.

Constantia's approach

When allocating our investors’ capital, we try to understand whether the expectations embedded in the market price of the businesses we own bear at least some semblance to reality when applying a reasonable range of estimates. We try to control for fundamental risk by sticking to businesses that have strong balance sheets and generate meaningful amounts of cash. (As the wisdom goes: revenue is vanity, profit is sanity, but cash is king.)

In short, we think that by sticking to a defined and repeatable process will serve investors a lot better than trying to claim the first prize in a Keynesian Beauty Contest.

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