History has all but forgotten Pang Cong. But we shouldn't forget the critical lesson he taught us.
Two and a half millennia ago, China was a jigsaw puzzle of seven separate territories. As ancient city-states were wont to do, they constantly tried to conquer each other. War was profitable back then—the victor got to claim its vanquished enemies' treasure and pillage its citizens. Not like today, when modern weaponry reduces the loser of any conflict to a smoking crater.
Because of the constant threat of invasion, the cluster of Chinese city-states was an ever-shifting tangle of alliances. One day, the Yan and Qin states might be bitter enemies. The next, they would unite because a bigger, badder city-state was threatening to decimate both of them.
But while the different states often needed each other to survive, they didn't trust each other one bit. So to keep their tenuous alliances honest, they implemented a primitive version of “Mutually Assured Destruction.” When one state allied with another, they would exchange princes as hostages. This incentivized each king not to betray the alliance, because doing so would result in his son's head on a spike.
During one of these princely exchanges, an unlucky prince from Qin was to travel to the Handan province to serve as hostage. The aforementioned Pang Cong, a high-ranking official and one of the king's most trusted advisors, was to escort him.
One little-known fact about the ancient Chinese is that they liked to gossip. Pang Cong was worried that in his absence, those jealous of his lofty status would talk trash about him, purposely undermining his credibility and standing with the king.
So Pang Cong told the king a story.
“Your Majesty, if someone were to tell you that there was a tiger roaming the markets of our capital city, would you believe it?”
“No,” the king replied.
“What if two people told you there was a tiger in the market?”
“I might be suspicious of it, but I wouldn't believe it,” the king replied.
“What about three people?” Pang Cong said.
After pondering for a bit, the king admitted that, yes, he would believe there was a tiger in the market if three people said it.
Pang Cong said, “It is obvious that there is no tiger in the marketplace, yet three men saying so can make a tiger. Handan is further away from here than the marketplace. And the number of men wanting to slander me is far more than three. I hope your majesty can see my circumstances.”
“I understand,” the king replied.
But he didn't really understand. Just as Pang Cong feared, while he was away, slanderers poisoned his reputation. When Pang Cong returned from his journey, the king refused to see him.
The moral of the story? Many people saying and believing something creates a powerful lie. One that others are prone to believe. Three men make a tiger.
Here's where Pang Cong's story intersects with modern reality: countless tigers are strutting around the financial markets right now, masquerading as truth. Let's catch three of them by the toe to see where the “wisdom of crowds” goes wrong and why we should heed Pang Cong's lesson instead.
Tiger #1: Markets Are Efficient
Are markets efficient? Ask an average person with a respectable amount of financial knowledge this question, and I suspect he'll reply with a confident “yes.” The common belief is that markets immediately agglomerate all information about a particular asset into its price—therefore, unless you have inside information, beating the market is impossible.
To help evaluate that bit of conventional wisdom, let me tell you a story about a stock called Great Northern Iron Ore (GNI).
GNI is a trust that owns iron-producing property in Minnesota. What's so interesting about this stock is that it has a clearly defined expiration date. The trust agreement stipulates that the trust will terminate 20 years after the last surviving beneficiary dies, which happened in April 1995. So GNI will cease to exist on April 6, 2015.
On that date, the rights to the trust's underlying property pass to ConocoPhillips, and the shares become worthless. Shareholders will get a final liquidating distribution, which GNI management has estimated will be $8.39 per share.
GNI remits all of its quarterly net income to investors as dividends. Given that there are five quarters left until GNI terminates, we know that it will make five more dividend payments. Its dividend has declined in recent years, but let's be generous and assume it can continue to pay out at its most recent clip, which was $2.65/share in Q4 2013.
Let's do the math…
As you can see, a share of GNI is unequivocally worth no more than $21.64. And in reality, it's worth less, when you factor in the time value of money and taxes.
All of this information has been available for several quarters. But as recently as January 3, GNI was trading for $65/share. Anyone who bought at that price—and plenty did—was effectively trading a dollar for 33 cents.
Valuing companies usually involves a great deal of subjectivity. But not in this case. We know the terminal value. We know the distributions. We know every dollar that GNI will produce before it terminates.
In other words, we know pretty much exactly what GNI is worth. Yet the market assigned it a value of more than triple that.
As the cyberkids like to say: WTF?
The allure of lucrative dividends seems to be the culprit—GNI paid out a hefty 18.2% in 2012. Apparently that fat quarterly paycheck blinded investors to the fact that they were trading dollar bills for dimes. The price of GNI did come crashing down recently. But as I write, it's still priced at a too-rich $22.65.
So are markets efficient? Clearly not. They do assimilate all available information. But some information is bad. Humans are imperfect and are driven by more than pure logic. In this case, dividend chasers kept GNI sky-high when it deserved to be much cheaper.
Pang Cong: 1
The Wisdom of Crowds: 0
Tiger #2: Gold Can't Be Manipulated
With gold mired in a prolonged correction, the idea that large traders are suppressing its price is a hot topic. Despite a vociferous minority that claims otherwise, the prevailing notion is that manipulation, at least in an attempt to turn a profit, is impossible.
That conclusion seems intuitive: sure, a big-time trader could sell a boatload of gold all at once to depress its price. But to turn a profit, it would have to buy the gold back at those lower prices, which would undo the initial effect. Case closed, right?
Actually, no. By far the best and most lucid explanation I've seen on the matter is Casey Research Senior Economist Terry Coxon's recent article in The Casey Report, “How to Piggyback on Gold Market Manipulation.” He explains that under certain economic conditions, not only is it possible for a big investor to push the price of gold around to turn a profit, but that “in the entire investment universe, gold is the asset most likely to be manipulated by big purchases and sales.”
It's truly an eye-opening piece. Terry even concludes with two strategies that gold investors can use to take advantage of the potential manipulation to buy gold at better prices.
If you'd like to read the article but aren't a subscriber to The Casey Report, consider taking it for a test drive. Our generous refund policy allows you to receive three new issues—plus peruse our entire archives of over 60 issues—before deciding if it's for you. If it's not, no problem—just cancel within 90 days for a full refund. Click here to subscribe to The Casey Report.
Pang Cong: 2
The Wisdom of Crowds: 0
Tiger #3: Invest in Countries with Rapidly Growing GDP
I shudder whenever I hear a pitch to invest in a certain country's stock market that begins with “Look at how fast its GDP is growing!”
That's because, counterintuitively, GDP growth rarely translates to strong stock market returns. In fact, many studies have found that there's no link at all between GDP and stock returns in the short and medium term; some even argue that the correlation between the two is negative.
China is the poster child for this phenomenon: the Chinese economy has been growing at over 7% per year since 1991, yet Chinese stocks peaked at the end of 2008 and have gone nowhere in the past five years.
To understand this strange dynamic, first recognize that a country's GDP and its stock market do not benefit from the same conditions. For example, the US economy (and therefore US GDP) thrives on low oil prices because America must import oil. But the S&P 500, which includes several prominent oil companies, benefits from high oil prices.
For emerging economies, the disconnect is even more severe. Many of the biggest companies in emerging markets are state controlled, or at least state influenced. If PetroChina has the potential to make a $1 billion profit per year, the Chinese government has every incentive to take $500 million of that profit and spread it around to Chinese citizens in the form of jobs and higher salaries. After all, Chinese citizens vote (sort of); foreign investors don't.
Of course, the Chinese government can't tell investors to take a hike and raid all corporate profits. That would discourage foreigners from investing in China. But it can and will pillage some profits. Profit maximization is simply not the Chinese government's #1 priority. Nor is it the priority of most emerging markets.
Remember that when investing—especially in immature markets.
The final tally:
Pang Cong: 3
The Wisdom of Crowds: 0
There you have it. To be fair, I'm sure we could find some examples of when the wisdom of crowds produced better results. But by and large, zigging when the crowd is zagging is a proven path to investment success. In fact, it's exactly how the most successful investors I know, including Doug Casey, made their fortunes.
I'll now pass the reins to a friend of Casey Research, Pete Kofod, who has some thoughts on how modern libertarians are often an embarrassing bunch. Regular readers will recognize him as the author of one of the best and most thought-provoking articles ever published in these pages, “The Rise of the Praetorian Class.”
After that, you'll find some classic tips from David Galland about how to invest in junior miners in Casey Gems.
I'll leave you with this quote, which is just too perfect not to share, given the subject of my above missive:
“No one in this world, so far as I know, has ever lost money by underestimating the intelligence of the great masses of the plain people.”
—H. L. Mencken