No. of Recommendations: 10
ChatGPT’s take to this morning’s musings:
You are observing something that many value investors eventually conclude: the stock market is not primarily a mechanism for allocating capital to the best businesses. It is primarily a mechanism for allocating capital according to flows, narratives, incentives, and time horizons.
The question is not “Why are there so many poor companies?”
The question is “Why are there enough buyers willing to own them?”
The first answer: Index funds are indeed supporting many mediocre companies
If a company is included in the S&P 500, Russell 2000, or similar indexes, every dollar flowing into index funds automatically buys shares regardless of quality.
Index funds do not ask:
* Is this company earning good returns on capital?
* Is management competent?
* Is the moat durable?
* Is the valuation reasonable?
They simply buy according to index weight.
This creates a structural bid under many mediocre businesses.
However, this explains only part of the phenomenon.
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The second answer: Different investors have different objectives
You and Warren Buffett might ask:
“Will this business be worth significantly more in ten years?”
Many market participants are asking something entirely different:
* Can earnings beat estimates next quarter?
* Can the stock go up 20% before year-end?
* Can I trade the momentum?
* Can this company get acquired?
* Can I raise another venture round?
A business can be a terrible long-term investment and still be a good speculation.
The market contains:
* traders
* hedge funds
* arbitrageurs
* option market makers
* venture investors
* growth investors
* passive investors
* retail speculators
All are playing different games.
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Biotech is perhaps the purest example
You specifically mentioned biotech.
Most biotech companies are not really operating businesses.
They are essentially:
scientific options contracts.
A typical biotech:
* loses money
* has no revenue
* issues stock repeatedly
* depends on a few clinical trials
Yet it may have a $500 million market cap.
Why?
Because one successful drug could someday be worth several billion dollars.
Investors are not buying current earnings.
They are buying a lottery ticket.
Consider companies developing:
* cancer therapies
* Alzheimer’s treatments
* obesity drugs
* rare disease drugs
One success can produce enormous returns.
Most fail.
A few become the next Amgen, Regeneron Pharmaceuticals, or Vertex Pharmaceuticals.
The winners pay for many losers.
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Why can poor companies keep issuing stock?
Because hope is always for sale.
Suppose a biotech has:
* $50 million cash
* burns $20 million annually
Two years later it needs more money.
Management sells new shares.
Who buys?
Typically:
* specialized biotech funds
* healthcare hedge funds
* venture-style public investors
* institutions averaging down
* retail investors attracted by the story
As long as investors believe there is a chance of a breakthrough, capital remains available.
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The third answer: Agency problems
Many professional managers are not rewarded for absolute returns.
They are rewarded for:
* assets under management
* short-term relative performance
* staying close to benchmarks
A fund manager who buys a fashionable but expensive stock and loses money alongside everyone else often keeps his job.
A manager who avoids fashionable stocks and underperforms for two years may lose his job even if he is ultimately right.
This creates enormous support for popular securities.
Buffett has discussed this repeatedly.
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The fourth answer: Survivorship blindness
When you examine Value Line you are seeing today’s population of companies.
Many terrible companies have already disappeared.
Thousands have:
* gone bankrupt
* been acquired
* been delisted
* merged away
The market constantly recycles capital through new hopeful enterprises.
It’s similar to nature:
Many seeds are produced because few become trees.
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Why aren’t valuations lower?
This is where your observation becomes particularly interesting.
Historically, many mediocre businesses traded at:
* 6× earnings
* 8× earnings
* 10× earnings
Today many trade at:
* 18× earnings
* 25× earnings
* 30× earnings
Several forces contribute:
1. Passive flows
A constant buyer exists.
2. Retirement system inflows
Every two weeks millions of workers contribute to:
* 401(k)s
* IRAs
* pension plans
Much of that money automatically enters equities.
3. Low interest rates conditioned investors
Even though rates rose recently, investors spent over a decade valuing stocks as if capital were nearly free.
4. Scarcity of public companies
An overlooked point.
The number of U.S. listed companies is much lower than in the late 1990s.
Fewer public companies compete for a much larger pool of investment capital.
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Who is supporting the equity values?
If I had to rank them:
1. Passive index funds
2. Retirement-plan inflows
3. Institutions forced to stay invested
4. Momentum and growth investors
5. Retail investors
6. Speculators seeking optionality (especially biotech)
The farther you move from profitable, cash-generating companies, the more the shareholder base shifts from investors toward speculators.
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Why Buffett, Markel, Exor and Investor AB look unusual
This ties directly into many of the companies you have researched.
When you look at:
* Berkshire Hathaway
* Markel Group
* Exor
* Investor AB
you are looking at organizations whose primary goal is:
compound capital over decades.
That is actually rare.
Most public companies optimize for:
* quarterly earnings
* stock promotion
* executive compensation
* growth at almost any cost
The reason you often feel disappointed after reviewing Value Line reports is that you are evaluating businesses through a long-duration owner-operator lens.
Viewed through that lens, the investable universe shrinks dramatically.
Buffett once remarked that if he could find 20 truly outstanding investments in a lifetime, that would be enough.
After reviewing thousands of public companies, many serious value investors eventually conclude something similar:
The surprising thing is not how many good companies exist. The surprising thing is how few exist.
