delanceyplace: delanceyplace.com 2/2/10 - uncritical investors and dumb ideas

In today's excerpt - George Soros, one of the
world's wealthiest and most successful
investors, made his early fortune by betting
on the stock market's irrationality in a
world that had long believed in a rational
and efficient market. Investors fell in love
with conglomerates such as LTV Corporation in
the 1960s, and that love translated into
unwarranted high valuations for these
companies and soaring stock prices. For
Soros, that was a golden opportunity:

"Soros's practical experience as a broker and
research analyst convinced him that the
normal market state was, in fact, disequilibrium.
As an investor, however,
he finds it more useful than an assumption of
market rationality,
because it is a better pointer to profit
opportunities. [One] of his
early investment successes [was] crucial to
the evolution of his
thinking.

"[It] was related to the conglomerate
movement in the second half of the 1960s. The
flurry of company takeovers, Soros
saw, merely exploited investors' tendency to
rate companies by
trends in earnings per share (EPS). Start
with modestly sized Company A, and engineer a
debt-financed acquisition of B, a much
larger, stodgy company with stagnant
revenues, a modest EPS,
and a low market price. Merge B into A, and
retire B's stock, and
the resulting combined A/B will have a much
higher debt load,
but a much smaller stock base. So long as B's
earnings more than
cover the new debt service, the combined A/B
will show a huge
Jump in per-share revenues and earnings.
Uncritical investors then
push up A/B's stock price, which helps
finance new acquisitions.
Jim Ling was one of the early exploiters of
the strategy, parlaying
a modest Dallas electronics company into a
sprawling giant (LTV) with
dozens of companies, spanning everything from
steel to avionics,
meatpacking, and golf balls.

"Business schools justified the scam by
theorizing that conglomerates deserved higher
share prices because their diversified business
mix would deliver smoother and steadier
earnings. It was the kind
of dumb idea that underscores the disconnect
between business
schools and real business. If shareholders
want earnings diversification, of course,
they can quickly and easily diversify stock
portfolios in the market. Big conglomerates,
in fact, probably warrant
lower stock prices. They're hard to manage,
are often run by financial operators, and
usually carry outsized debt loads.

"Soros understood that the conglomerate game
made no sense,
but he also recognized its strong following
among market professionals. 'I respect the
herd,' he told me, not because it's right, but
because 'it's like the ocean.' Even the
stupidest idea may warrant
investment, in other words, if it has a grip
on the market's imagination. So Soros
invested heavily in conglomerates, riding up the
stock curve until he sensed it was nearing a
top. Then he took his
winnings and switched to the short side,
enjoying a second huge
payday on the way down."

Charles R. Morris, The Sages, Public
Affairs, Copyright 2009 by Charles R. Morris,
pp. 10-11.

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