In This Episode
You’ve probably heard Warren Buffett say, “Be greedy when others are fearful and fearful when others are greedy.”
You probably never stepped back and realized that’s a model of how emotions affect the stock market. In this week’s opening “Rant” segment, Dan shares with you his model of the basic emotional makeup of the stock market. It’s different than the Buffett model.
Dan pulls evidence in from some interesting sources he’s been looking at recently, from physicist/quant investor Emanuel Derman and mathematician/author Steven Strogatz.
Then, in this week’s “What’s New” segment, Dan will share his insights on a new report by Wall Street firm research firm AB Research, and how it aligns with an important message he’s been telling investors for over a year now: value investing is rapidly becoming the go-to strategy for beating the market, for the first time in many years. Then he’ll scan the headlines of the Wall Street Journal and tell you why there’s a mistaken idea at work in them—and in many investors’ minds, regarding the purpose and expectations of companies that have recently gone public. It’s not what you think.
In this week’s interview segment, Dan talks with behavioral finance expert, Dr. Daniel Crosby. The discussion plumbs deep into the reasons why emotions can make investing difficult. Dr. Crosby leaves listeners with hope, and tells you several concrete ways to improve your own trading and investing by better understanding your own emotions.
In this week’s Mailbag segment, Dan reads a single email and deals with a very important misconception about the valuation of royalty and streaming companies, using the example of his very favorite royalty company.
NOTES & LINKS
- To follow Dan’s most recent work at Extreme Value, click here.
00:01:39: Dan recommends the latest book he’s been reading and says, “I’ll definitely be reading it again very soon…it’s that good.”
00:02:00: The difference between a model and a theory
00:03:20: Dan says, “I’m hoping to improve the quality of your thinking with this model…”
00:15:19: Dan gives you, “An updated version of Warren Buffett’s famous advice.”
00:15:55 What to buy instead of the same 500 stocks everybody else is buying.
00:17:10 What’s New this week…
00:17:24: Dan shows you, “Another sign that being a value investor is about to be a much better strategy than paying any price for rapid growth and no profits.”
00:20:24: Dan scans the latest Wall Street Journal headlines on IPOs and tells you what’s wrong with them.
00:21:23: What you should really expect from the performance of IPOs, and why.
00:22:57 This week’s interview with behavior expert Dr. Daniel Crosby
00:28:26 “Our brains haven’t had an upgrade in about 200,000 years.”
00:29:46 The stress response of being chased in a dark alley and watching your Uber shares fall is the same to your body.
00:31:22 Dr. Crosby tells you how your body “stores” traumatic experiences in the stock market
00:36:06 The kind of people who are very good financial decision makers.
00:37:02 When to “sit it out” in financial markets.
00:38:09 What you can do to keep your emotions to keep from harming you financially when operating in financial markets and making financial decisions.
00:40:31 Three elements you must have to develop a successful stock market trading system.
00:42:01 How to develop “Olympic athlete” level discipline by being lazy.
00:46:33 The four biggest ways emotions keep investors from succeeding.
00:50:44 Dr. Crosby leaves you with one valuable thought.
00:51:27 This week’s Mail bag segment…
00:54:32 Dan defines the intrinsic value of a company and talks about the reasons why P/E ratio isn’t a good way to think about the value of mining royalty and streaming companies.
Announcer: Broadcasting from Baltimore, Maryland and all around the world, You're listening to the Stansberry Investor Hour. Tune in each Thursday on iTunes for the latest episodes of the Stansberry Investor Hour. Sign up for the free show archive at InvestorHour.com. Here is your host, Dan Ferris.
Dan Ferris: Hello, and welcome, everyone, to another episode of the Stansberry Investor Hour. I am your host, Dan Ferris. I'm also the editor of Extreme Value, a value investing service published by Stansberry Research. We have a really interesting show today. I kind of tried to make a little theme here between the rant and the guest who is really a cool, cool guy – Daniel Crosby – we'll talk with him later. So let's get started with the rant.
OK, this week I'm going to give you one of my little pet theories. Actually, it's not a theory. That's one of the things I learned in the past couple weeks, the difference between models and theories. So... mine is a model, and my little model is about the dominant emotion in the stock market, so – and it's probably really the dominant emotion at extreme highs and extreme lows. And I'm giving this to you, it's kind of a – like I said, it's a pet theory or pet model of mine, because it's different from what you normally hear, OK? So, first of all, I said models are different from theories.
There's a really good book I'm reading – actually, I'm, like, literally two pages from the end. [Laughs] I stopped just two or three pages from the end yesterday afternoon. It's called Models Behaving Badly, by Emanuel Derman. It's like 200 pages, it's loaded with stuff – I will definitely be reading it again very soon. As a matter of fact, I might finish it today and then just start on it again because it's that good. And one of the things he teaches you is the difference between models and theories. So a model is just a – it's a simplification, it's a representation, it's like a metaphor or an analogy of something else.
It's incomplete, but it's supposed to be enough like the thing that you're modeling to be useful. But a theory is different from that. A theory is like a fact. It's inseparable from the thing you're theorizing. Maxwell's equations are – they are electricity. That – or I'm sorry, the electromagnetic field, right? And... etc., etc. Or I guess we could Newton's theory, you know, of the planetary motion. That is planetary motion.
And this fellow George Box was a British statistician. He said – he summed up models. He said, "All models are wrong but some are useful," and I'm not even totally sure of the use of my little model, but it's different and I think that – I think it's important to think clearly. And in fact, I have this book by one of our former guests on the show, Shane Parrish. It's about mental models, and the subtitle is The Quality of Your Thinking Depends on the Models in Your Head, and so I think this – I'm hoping to improve the quality of your thinking as an investor with this model.
OK, so the standard emotional model of the stock market has two extremes, right? We're greedy at the top and we're fearful at the bottom, and you've all heard this I'm sure and you've all heard perhaps the most famous proponent of this, Warren Buffett say, "You have to learn to be greedy when others are fearful, and fearful when others are greedy." That supports that basic emotional model of the market. That doesn't seem really right to me. It requires people to follow – it's like your basic emotional makeup changes too much to me depending on the direction of the market, right?
And greed doesn't feel like the right one because it's – greed is an intense, selfish desire for something, and if greed were the primary motivator you'd think that an intense, selfish desire would lead you toward activities that would increase the likelihood [laughs] that you'll get the thing you're greedy for, right? But it doesn't seem to do that, you know, whether it's money or whatever kind of a thing it is that you're greedy for. At the very least, if it is greed it's working way against [laughs] folks. So it seems to me like there's something more powerful than greed in operation.
So my emotional model of the stock market is very, very simple. It says first of all that the dominant emotion in the market never really changes because the primary human motivations never change, and there's one primary one that my model is based on. It says the fear of not being like other humans, right? It's the fear of being different, of doing something different than other people, right? So we're all more afraid of not being like other humans than we are of almost anything else that's not physically harmful, but as a matter of fact, even quite a bit of physical harm is endured by folks who, you know, are doing things to try to be like others, right?
Well, you know, people – you can just imagine, you know, people wearing uncomfortable clothing or marking up their bodies with tattoos or doing, you know, other painful things so they can be like everyone else. So we're all kind of constantly performing for one another throughout our lives in hopes of getting this approval and being like everyone else, right? Remember Shakespeare in As You Like It? The character Jacques, Act Two, Scene Seven. "All the world's a stage, and all the men and women merely players. They have their exits and their entrances and one man in his time plays many parts, his acts being seven ages," etc., etc.
So yeah, we perform for one another out of a purely selfish motive too, right? And this is the way, for example, in nature birds and fish appear – they do the same thing. Birds and fish, when they swarm the way they do they appear to be acting altogether in concert, right? But we found, so I'm told by people who know [laughs], that they're really acting individually to minimize the chances they'll be caught by a predator. So when you see those swarms of birds doing those beautiful, you know, shapes in the sky they're trying not to be caught by a predator, and the same thing with fish.
And I think humans tend to swarm, too. I saw a great video recently by a guy named Steven Strogatz who is very good at making math and scientific subjects a lot of fun to learn about, and he has a Ted Talk called "How Things in Nature Tend to Sync UP," and it's – and he spends a lot of time on swarms, and he quotes this guy, Iain Couzin from Oxford who talks about the laws of swarms, right? So the laws of swarms are one – there's four of them – all the individuals are only aware of their nearest neighbor, all the individuals have a tendency to line up, right, to want to go in the same direction, all individuals are attracted to each other but they try to keep a small distance apart, one body length for fish, three body lengths for birds, generally speaking.
And then the fourth law is when predators are coming get out of the way. [Laughs] So it looks like a collective behavior but it's not, and each individual is acting to save itself. It's essentially trying to hide behind the others. So for humans, you know, the predator is substituted with, you know, whatever complex emotions we'd rather not feel, whatever bad thing is going to happen, and the bad thing I'm suggesting in the market is not being like everybody else, right? So I would say the dominant emotion in the market at all times is fear. It's not greed. It's always fear.
Fear of not being in at the top, fear of not being out at the bottom, and the fear of not buying what everybody else is buying on the way up and not selling what everybody else is selling on the way down. Fear of not – it's the same fear that people have in all kinds of situations where – you know, social situations, right? Same thing. So it's not greed, really. If greed were the dominant emotion, you know, you think that would overwhelm other emotional responses and you'd act in order to guarantee that the object of your desire were something you got – you know, that you made a lot of money in the stock market, but people don't do that. [Laughs]
I certainly acknowledge the role of greed. It's definitely there. But I'm just saying the dominant emotion at the top of the market, which I think we're at or near, it's different. It's fear. It's the fear – you know, people call it – people like to use this phrase, "FOMO," "fear of missing out." That's it. It's the fear of missing out. It's the fear of not being like everyone else.
When everyone else is buying, therefore you're afraid not to buy. So, you know, what do people really do? I mean if you just – we'll talk with our guest today about what people are sort of programmed to do, you know, by evolution and – versus what they ought to do, but I think no matter how you look at this, only the fear of staying in and – getting in and being in and staying in explains the top, you know? Eventually, of course, everybody who wants to be in the market, who wants to buy is in and, you know, eventually [laughs] things start to go the other way.
You know, the swarm smells a predator coming, right? Whether it's Chinese trade talks or inflation fears or, you know, falling S&P 500 earnings or whatever it is, you know, the swarm tends to smell it and each individual acts on their own and then there's this aggregate behavior that kind of comes out, which we call a market crash or a bear market or, you know, bull market is the same thing. It's the same aggregation of this fear of not being like everyone else. So that's really it. That's my whole schtick.
That's my whole model of emotions in the stock market. I don't really have – like, you know, I can't tie this up in a neat bow for you. I can't tell you, well, because you know this you can make a million dollars because all you have to do is blabbity, blabbity, blah. But I just think that if you aren't thinking clearly about these things you're going to screw up and you're going to count on – for example, you may count on others' greed at the top and you may count on – you know, you can probably count on if you're at the bottom, but you may count on it too much and then of course, you know, the bottom turns around eventually as well.
So what are you counting on others to do? Because that's what we're doing in the market. If you read people like Howard Marks – he's a good one to read – you have to be aware of what other people in the stock market are doing. If everybody wants to do something it's probably a bad bet. You know, so if everybody's afraid of not doing something – and remember, there was an episode previously where we talked about negative behavior, defining your behavior negatively, and we're doing that here, aren't we? We're saying things that you're afraid not to do.
You're afraid not to be in at the top. You know, if there's something in the market you're afraid not to own – I'm sure there were plenty of people who were afraid not to own Tesla when it was pushing toward $400 and, of course, there are other evolutionary responses that keep people from selling, you know? They don't want to sell when they're underwater, and I think a lot of those folks are underwater now because this Tesla's story starting to fall apart. So – and, you know, at the bottom, of course, they'll all be afraid to own it. They'll be afraid not to sell it.
And all of this – maybe it's not as powerful [laughs] for you as it is for me but it's a pretty powerful model, this fear of not being at the top, fear of not being at the bottom. It reminds me, for example, of Blaise Pascal, the philosopher who said of all – "all of humanity's problems stem from man's inability to sit quietly in a room alone." Now I've certainly met people in my life who I'm convinced are – you know, if they sit in a room alone they become fearful, right? They're afraid, in other words, not to be with other people. They're afraid not to be doing.
That's what I get – that's part of what I get from that quote, that a lot of people are afraid not to be with other people and, you know, I think we could – so you can add to this, right? A substantial number of humanity's problems come from constantly comparing yourself to others and being afraid that you won't be like them, you won't measure up to them, that you're not recognized, you're not as rich, you're not as attractive, you're not whatever, and I think that enters into the market. I'm afraid not to make as much money as my neighbor is making, I'm afraid to lose more than he's making at the bottom, right, I'm afraid not to own what he owns on the way up and not to sell what he sells on the way down.
I'm also reminded of – you know, when we get toward what this is worth and what the solution of this is, I'm reminded of a film called The Neverending Story. It was kind of a – I think it was rated "G." It was a good family film and it was kind of a fantasy thing that took place in a, you know, far off, make-believe land. At one point in the film the hero has to pass between two large statues that basically will – I think they, like, shoot laser beams out of their eyes or something and they'll kill you if you are not – I think it was – the way they phrased it was the man who knows his own worth, something like that. And the market is like that, too. The market will kill you if you don't know your own worth and your limitations and if you don't know yourself emotionally and if you aren't really – if you aren't honest with yourself.
For example, recently I read something that suggested that investors don't know their own time horizon. In other words, people say, "Well, I'm a long-term investor." Yeah. [Laughs] You're a long-term investor until the market drops 40% [laughs], and then all of a sudden you're a trader who wants to minimize short-term drawdowns, [laughs] you know? That's how we really are. So it's hard – the point of that is it's hard to know yourself, but you need to know yourself and you need to understand that fear is driving it.
The fear of not being like other folks is driving you a lot more than you probably admit. So, you know, at the very least I believe it is worth something to give ourselves an updated version of Warren Buffett's famous advice and, you know, instead of maybe simply trying to say you want to be greedy when others are fearful and fearful when others are greedy, maybe you want to learn to be afraid of being too much like other investors at any given time. It may amount to a similar thing but I think it's subtly different, because you'll wind up doing – I mentioned Howard Marks.
Marks is always talking about how if you want to make money in the stock market you have to hold a portfolio that looks different from the – from what most people are holding, right? So if everybody's indexing and buying the same 500 stocks maybe you want to buy less of those or none of them and buy something else. And in the pages of my newsletter Extreme Value we've been pretty much doing that. We now have three – count them – one, two, three stocks related to the mining industry. Now they're not mining companies, and I don't want to get into all that.
If you're an Extreme Value reader, you know what they are. But the reason we're buying those is because most people don't own that stuff. Most people don't own it at most times, but people have really fallen way out of love with it in the past few years, ever since the – there was a four-year brutal bear market in gold stocks and, you know, they're still kind of not very far off the bottom and there's some really good deals on some really great business models and great management teams, you know, stuff with limited downside and huge upside potential that you just don't get when you buy those other, you know, 500 stocks that everybody wants to own.
So the dominant emotional in the market is at all times is the fear of not being like everyone else. That's the rant for today. Let's talk about what's new.
A couple of things this week. Just a couple before we get to our interview. The first one is – well, look. I'm a value investor, so you're going to get this stuff now and then. You're just going to have to deal with it. [Laughs] Another sign that being a value investor is about to be a much better strategy than just paying any price for rapid growth and no profits, a report by AB – Bernstein, the research firm – and they say that the valuation spread between cheap stocks and expensive stocks is at its widest point in 70 years. So if you look at the cheapest stocks in the market and the most expensive stocks in the market and you basically subtract the – you know, figure out some valuation criteria and subtract the cheap from the expensive, right, that difference is at its greatest point in 70 years.
So in and of itself maybe you say, "Who the hell cares?" [Laughs] Well, you should because, as they also point out – and the fellow who wrote this report is Inigo Fraser-Jenkins – value, buying the cheapest stuff as a strategy, as an investing style tends to outperform when this dispersion, he calls it, is wide. Also, it's when the dispersion is this wide and when there have been downward earnings revisions, and we had those, right? So S&P 500 earnings, you know, there have been downward revisions and earnings and the difference between the cheapest part of the market and the most expensive part is at its widest in 70 years, and this is – you know, this is another – as far as I'm concerned it's just more fuel in the fire of the admittedly grindingly slow [laughs] transition from a market obsessed with growth at any price, profits are not – you know, unprofitable growth just hasn't meant anything.
But I have to note that the Beyond Meat IPO we talked about the past couple weeks, that thing is up hundreds of percent. I think it's been public for, what, two weeks, three weeks – two or three weeks – and it's up hundreds and hundreds of percent. It trades at something like 50 times sales, and so that one has, you know, soared and a bunch of them have soared, but Uber and Lyft – you know, Lyft is down, like, 50% since it went public, and of course, Uber – it might've just picked a bad moment to go public, but it's down too.
And, you know, the bloom is off the Tesla rose I believe and it's getting worse, so maybe we're grinding into a transition here from growth – unprofitable growth at any price to buying cheap stocks with good fundamentals. And speaking of IPOs, the other thing I just wanted to mention was I did this little search – and let me just get it in front of me here – I did this search on – about IPOs just on the Wall Street Journal and, you know, I pulled up all these headlines. One of them says, "Uber Has Poisoned an IPO Market That Was Sick Anyway," "Uber and Lyft Get Creative With the Numbers but Investors Aren't Blind to the Losses," "Uber Stock's Plunge Is a Blemish on the IPO Market."
There was another one. "Uber's High-Profile IPO Upsets with Weak Debut." I thought there was another one. But anyway... you get the message, right? This – the narrative here is that there's something wrong with IPOs that fall once the company – you know, immediately after the company goes public, but I think that's just a sign of the times, that people expect an IPO to soar after the thing goes public. Look – an IPO is an exit, right? They're selling. They're selling stock.
When people say, "This company is going public," it means this company is going to sell a giant chunk of itself to the world. [Laughs] OK? So it's no surprise that, you know, if they do their job right the stock falls after it goes public, because their job is to get the highest possible price they can get, and to me it looks like they did that with Lyft and it – you know, they certainly did it with Lyft. The thing's down 50%. [Laughs] And it looks like they've done it with Uber as well.
So the real mystery is why a company like Beyond Meat, this, you know, company that makes plant-based meats soars, right? That's the real mystery. It goes from – you know, I think it IPO at like 11 or 10 times sales and then it's – now it's in excess of 50 times sales. It's up hundreds of percent. It's crazy. So that is really – that's really all that's new this week and I just wanted to point that out to you because we have – you know, these are alternating, they're kind of different signs of the times, the movement from, you know, growth to value and this belief that IPOs should soar, [laughs] you know, after they – after the stock goes public, when the rational expectation ought to be the exact opposite.
All right. So let's get on to our interview right now.
This week's guest is Daniel Crosby, educated at Brigham Young and Emory Universities, Dr. Daniel Crosby is a psychologist and behavioral finance expert who helps organizations understand the intersection of mind and markets. Dr. Crosby's first book, Personal Benchmark: Integrating Behavioral Finance and Investment Management, was a New York Times bestseller. Nice. His second book, The Laws of Wealth, was named the best investment book of 2017 by the Axiom Business Book Awards and has been translated into five languages. His latest work, The Behavioral Investor, is a comprehensive look at the neurology, physiology and psychology of sound financial decision-making.
When he is not consulting around market psychology, Daniel enjoys exploring the American South, fanatically following St. Louis Cardinals baseball, and spending time with his wife and three children. Please welcome: Daniel Crosby. Daniel, welcome.
Daniel Crosby: Yeah, thanks so much for having me.
Dan Ferris: Yeah, that was – that's a – you've done a few things in your life. You've written a few books and done a few things, huh? So...
Daniel Crosby: Yeah, well I like doing hard things that pay poorly, what can I say?
Dan Ferris: [Laughs] I feel you. I was a music major in college. So... let's get to know you a little bit. Like how did you come to this? Were you – it seems like you've been studying psychology for some time, but how – what was your life like growing up that kind of – were there any, you know, events or things about your – the way you were raised that led you to this? You know, admittedly, you know, not a lot of people do this, so how did you get into it?
Daniel Crosby: So I grew up the son of a financial advisor, so that was definitely formative. So, you know, I grew up talking about investing, talking about stocks at the dinner table, so this has always been a passion of mine, and so was a missionary for a couple of years and came back with a desire to help people and so went into psychology. And then, you know, a long story short, wanted to find a blend away – find a way to blend my two great loves of learning about human behavior and studying capital markets, and here we are at behavioral finance which sits squarely at the intersection of those two roads.
Dan Ferris: So let's talk about your book, because, you know, I have the book and I actually haven't read every word of it, but I looked through it and I think I've – you know, I've probably read, like, most of it, and I noticed something. [Laughs] The whole first part of the book, it's like – I get to the first – end of the first section and I'm like, boy, I never want to go near the stock market again. It seems like you're telling me that we're evolutionarily sort of set up to do anything but succeed in the stock market.
Daniel Crosby: [Laughs]
Dan Ferris: Is that an unfair characterization, or... ?
Daniel Crosby: No, I think that's quite fair. I mean I sort of like to joke that, you know, God could not have created a worse investor than you or I. When you study the – you know, everything from the brain science to the way that our society operates, sort of everything [laughs] within us and everything outside of us is set up first to make poor financial decisions but, you know, taking that as a starting place I think once you're aware of some of these problems you can start to combat them. So hopefully you get to some of the more optimistic stuff, because I think you should go near the stock market, and indeed, I think you have to if you're either going to keep – you know, keep up your standard of living, but you have to be kind of frank about how the cards are stacked against you and I think that's a fair description.
Dan Ferris: So let's talk about that a little bit. Like if you had to sort of sum up, you know, the – either the one way or, you know, if you could sum it all up in one idea or if there are like two or three main ideas, like what's the big problem with us humans?
Daniel Crosby: I think I can sum it up in a couple of ideas. You know, so if you look at the societal piece, which I think is seldom considered, you know, we know that the number one thing we have over the rest of the animal kingdom, because we're animals – we forget this sometimes, but we're animals too – and the thing that we do better than any other animal species is that we believe in things that aren't true but we agree upon and they help us to operate. So anything from, you know, the borders of a country to the laws of a state to the, you know, structures of a religion and everything in between, these are constructs that we agree upon and give form and function to our lives but they aren't strictly true. I mean they aren't strictly true in the most concrete literal sense. And so in a very real sense humankind's greatness is its ability to agree on and cooperate around these what we'll call functional fictions.
Well, that's a good way to build a society but it's a bad way to make decisions in the stock market where you're going to want to be objective and impersonal and on a fact-finding mission. And so, you know, I go into a great deal of detail in the book, as you know, about how this tendency to believe in things that aren't true but are useful can help us in other facets in our life but can hurt us when it comes to investing. And then when it comes to our brains, our brains haven't had an upgrade in nearly 200,000 years. They account for 2% to 3% of our body weight but 25% to 45% of our energy consumption in a given today, and so because there's such a mismatch between size and consumption we're always looking for ways to think less.
This is just a truth of humankind. We're always looking for ways to think less. And again, that's fine if you're just trying to get through your day, but thinking less and shutting your brain off and shutting off the parts of your brain associated with critical thinking and decision-making is not a great way to approach capital markets. So those are just two quick examples of how the deck is stacked against us a bit.
Dan Ferris: OK. So I'm just going to grab – not really at random – but let's just say at random just a couple of ideas from the end of one of your early chapters here. And you said – it says, "Taking financial risk causes real bodily pain." Gosh, that just makes me want to run right out and buy 100 shares of Google. I mean... [laughs] how does that happen? What do you mean by that?
Daniel Crosby: Well, so what's interesting is the stress response – you know, the stress response to being, you know, beat up in a dark alley or, you know, chased in a dark alley and, you know, watching your Uber shares fall through the floor, they're identical. You know, our body doesn't differentiate when we're having a negative response or a stress response. There's no differentiation made between a physical stressor and an emotional stressor.
Dan Ferris: Wait a minute. You're telling me that losing money on Uber or Google or whatever is like getting punched in the gut or something?
Daniel Crosby: Well, it's – the stress. Now getting punched in the gut is different. That's why I said being chased instead of being beat up. Now being beat up is its own set of circumstances, but yes, the stress response to being, you know, pursued by something that has you in danger and the fear you feel while watching your shares drop is identical and, you know, they've done studies on value investors, brain scans on value investors, like deep, contrarian investors, and it maps onto things like loneliness. You know, the loneliness of being a contrarian and the loneliness of being picked last at kickball or, you know, not getting asked to dance, these are identical phenomena. So it's a fascinating thing to understand that there's real risk, there's real pain, there's real loneliness in being, you know, a thoughtful contrarian investor.
Dan Ferris: OK. I'm going to grab one more of these before we move on, and it's the one right underneath. It says, "Fear is impossible to extinguish since the body stores it for a rainy day." What does that mean?
Daniel Crosby: So this was a study done on rats that was – that were conditioned to fear a stimulus, so if you think back to your Psych 100 class and you learned about Pavlov and the salivating dogs, right? So this is the same kind of thing. The rats – they pair a stimulus like the ringing of a bell with an aversive stimulus like a shock, and so they condition them to be scared of just the bell, but then they take it back the other way. They extinguish it, they decouple that pairing so that the rats no longer expect that, they're no longer scared of the bell. But then what they did was they severed the corpus collosum, the part that connects the two hemispheres of the brain. They ring the bell again and the rats freak out – the rats are scared again.
So we find and what we assume is true about humans – it's not quite as easy to do these kind of studies on humans – but what we find in rats and assume about humans is that there is a physical place in the brain where strong emotional responses are stored. So we have a place in our brain that says March of 2009 – not a metaphorical place. A physical marker in our brain that stores traumatic experiences from the stock market, and so we hang o to that. The body hangs on to fear and loss. Because if you think about loss in primitive times you only get one shot, right? You only get one shot to not get eaten by the tiger.
You know, you're being caught by the tiger or the bear or whatever is a one-time deal. So if you have a close call you want to hang on to that bad memory forever and not repeat it, so our body is in the most literal sense possible conditioned to hang on to fear in a very physical, tangible way.
Dan Ferris: So just – you know, with the negative emotions that you describe in the book, I almost feel like being in the stock market is like being at war for some people, for most of us, or being in a fight or at war or something. I mean like you said, it's not a physical – it's different when you're getting punched in the gut, but at least – at the very least it's like we're all kind of being chased by somebody who wants to do us harm [laughs] the whole time we're in the market.
Daniel Crosby: Well, it's interesting, right, because the market giveth and the market taketh away, because there was a Harvard study I cited in my book previously that looked at brain scans of day traders and tried to map, you know, sort of the euphoria a day trader feels on a good day against the brain scans of people engaged in other activities, and the closest link they could find between a successful day trader was someone who was doing drugs and so, you know, they call drugs "dope" because it's a dopamine rush and there's a dopamine rush when you're having success. [Laughs] You know, there's norepinephrine when you're having a bad day. So it is at times like being at war and at times it's like getting high, [laughs] so being in the market will have you all over the place for sure.
Dan Ferris: Right. So I'm glad you mentioned the positive emotion, because now I'm looking in chapter seven of your book – Chapter Seven is just called "Emotion" – and I'm on page 93 and I'll just read a little bit, and it says, "Happiness leads to greater reliance on heuristics or cognitive shortcuts," and then it says another study found that positive mood increases reliance on stereotypes to judge other people, and then there's – there's a lot more than that, but basically [laughs] after telling me that all these negative emotions are working on me to prevent me from being a good investor it's telling me that positive emotions are also kind of not making me [laughs] a very good investor either. So – like no matter how bad or good I feel I'm a bad investor.
Daniel Crosby: Well, the – it's interesting. So a couple of things. That study found that happy people were more racist, right? So you're happiness is kind of making you racist. That's – what they found though is like we when you're in a good mood you want to hang on to that good mood. You don't want to be disturbed from that good mood, and so it again leads you to think less. Instead of evaluating someone in nuanced, individual way you're going to evaluate them, you know, using shortcuts and maybe stereotypes about, "Oh, what this kind of person is like, what this kind of group is like." And so interestingly in that same chapter I talk about a couple of people who were shown to be really, really good financial decision-makers. Unexpected groups.
One was people who had traumatic brain injuries to the emotional processing centers of their brain. So these are people who can't basically feel emotion, and what they found was they were awesome gamblers, they were great investors, but they couldn't even pick out sort of what suit to wear or what kind of ice cream to have because even silly decisions like what flavor of ice cream to choose has an emotional undercurrent, but they were so dispassionate in the markets, in the gambling markets, in the stock markets, they were so dispassionate that they made wonderful decisions. So you make – you know, you're bringing up one of the main points of the book, which is, you know, strong emotion is no place to be making big decisions with your money. So, emotion's unavailable. We're always going to be in some sort of emotional state or another. Periods of really, really elevated fear or greed are a good time to sit it out.
Dan Ferris: Interesting. Because as you also pointed out in the book, basically without emotions we can't function. We're not human. No – you say at one point, "No emotion, no humans."
Daniel Crosby: No, that's exactly right.
Dan Ferris: Yeah, so that's what – that feeds into my idea. It's like we're kind of at war with ourselves. How – so how do we do this? Because another point that you make that a lot of the behavioral investor folks make is that knowing all this doesn't help much. [Laughs] I mean it doesn't change it any at least, right?
Daniel Crosby: Yeah, it doesn't help as much as you'd like it to for sure. One study I cited in the book found that people lose 13% of their IQ when they're under financial stress and, you know, some people don't have any extra 13% they're dealing with, and so when that's out the door, you know, all the good lessons are out the door. So I think there's a couple of things that we can take heart in. So the first is that studies show that practice helps. You know, Andrew Lowe and others did studies on traders who found that over time they get more familiar with what markets look like, they get more familiar with processes, and their emotions become less elevated to the upside or the downside. So take heart in knowing that practice helps.
I talk a lot about practices in the book like meditation. You know, some of the biggest hedge fund managers in the world are really skilled meditators. The CFA Society just came out with a great meditation program. And then another thing we can do is just follow a rules-based approach. You know, automate your trading and your investing to the extent possible and be slavishly – you know, slavishly follow your rules. I don't think it's any coincidence that some of the greatest investors of all time have been quants, have been rules-based investors, and I think there's some really profound behavioral reasons for that. So, practice helps, education helps some, and automation and rules-based investing help a ton as well. So all is not lost, don't worry.
Dan Ferris: So you mentioned the quants. I mean by now the story of Jim Simons and Renaissance has been told a few times. Of course they're loaded to the gills with PhD physicists and other science folks, and it's not – I mean, I hear you, you're trying to give me hope, and I want you to do that, but if I'm competing with those folks, good night. I mean how in the world – are you telling me that a regular person can really develop a system that I can actually understand that's not based on, you know, the theory of relativity or whatever these people are doing at Renaissance that works?
Daniel Crosby: Yeah. I think you can, and I don't think you need to be a Fields Medal-winning mathematician or work at Rentech to, you know, have success at this. I mean you'll even look at systems like Joel Greenblatt's, you know, earnings yield ROIC formulas and things like that, a lot of what they do is just constrain bad behavior. So I think – you know, I think there's three things that we want to look at when we're developing a trading system. You know, it needs to be based on data, you know, it needs to have some evidence in the literature, it needs to be philosophically sound, and then the third piece is it needs to be behaviorally hard to implement.
You know, look at anything from trend, momentum, value, all of these sort of enduring factors have a behavioral component to them, and so if you've got a system that ticks those three boxes – it's data-based, it's philosophically sensible, and it's rooted in some way in behavior – behavior is not going anywhere, and so if you can develop the discipline that I talk about in the book I think you're going to be in good stead and I do not think you have to be a rocket scientist to beat the market. I really don't. But I do think you need to have rocket science-level discipline. I think that's far more important than having a big brain.
Dan Ferris: OK, so rocket science-level discipline. So when you say that it makes me think of people like Olympic athletes, for example, and [laughs] again, I don't know if I want to compete with an Olympic athlete. You know what I'm saying? It's really hard to develop that level of discipline, it's – and my point is it's highly unusual, isn't it? It's like very few individuals really are capable of that, aren't they? I mean...
Daniel Crosby: Well, the cool thing about markets and the discipline that you need to trade or invest relative to what you need to be Michael Phelps is Michael Phelps has to get up every morning at 4 a.m. and, you know, swim two miles or whatever he does – we just have to set it and forget it. I mean a lot of times the real rigor, the real difficulty is in building a system and then monitoring it, but the great thing about an automated trading strategy is you can just kind of set it and forget it. And so I think there's – we have a leg up there and we don't have to be up – you know, I don't think we have to be up with the morning sun to be effective at these things because, you know, that's one of the great things. You can sort of automate proactive laziness, I guess. You can automate [laughs] – you can take this human tendency to be lazy and prone to the status quo, and if you lock in a good status quo then you're set. So I think we have an advantage over the Olympians and we don't have to work quite so hard, so take heart.
Dan Ferris: OK, so I don't have to be [laughs] a Rentech, you know, genius physicist, and I don't have to be an Olympic athlete, but I do need to do something. I wonder if we could give our listener sort of the generic version of the – you know, the portfolio or the method or what is it we can give our listener that he can use out of all this?
Daniel Crosby: So I take – you know, I outline this towards the end of the book. I give some sample factors, and the ones that I use are value and momentum, and I talk about basically high conviction automated value momentum combo strategies, and so that's – I mean that's sort of my personal gospel but, you know, other people – there's plenty of sensible ways to invest but I think that they all have a couple of things in common. I think that they account for behavioral risk, they are largely automated. There's a lot of evidence at this point to suggest for average folks locking in a rules-based system is going to beat discretion unless you've just got all day to consider the Chinese soybean futures market or whatever. [Laughs]
And so I think that good investing has a couple of themes in common, but it can take all different flavors, right? I mean there's all these different things. As long as they adhere to these three principles of being rooted in data, behavior, and a sound philosophy, I don't think you can go wrong, and the discipline that you need is not physical, it's psychological. You know, the discipline that you need – because even the best system – you know, even the best system's going to underperform, you know, a third of the time, let's say. I think the discipline that you need is to be able to stick with your system in good times and bad, and that's what Jim Simons said. You know, he says we slavishly follow the model even when we think it makes us look like idiots, and it will.
You know, it will periodically and you have to have the mental discipline to see it through. So that, I think, is where – that is where the pain comes in. It's not a physical pain. It's a mental pain of self-doubt and having to see yourself through tough times.
Dan Ferris: Yeah, and that statement by Simons is remarkable considering the fact that those guys just – you know, they win in the market year after year after year. They are just a force of nature and yet he kind of talks about it like the same way the rest of it might talk about it, like, well, you know, we can't win all the time but we gotta stick with it. I wish I could not win all the time as well as [laughs] Rentech doesn't win all the time. So let's try to be more concrete here. Like, what... can I do?
Let's say, you know, I come to you – and I realize you probably consult with, like, big corporations or something, but let's say, you know, Dan Inc. – a Dan Ferris Inc. investor comes to you and says, "You know, I think I'd be a lot better at this if I did something different and I don't know what it is and what –" you know, what would you tell me? What could you help me with?
Daniel Crosby: Well, you know, I think what you have to do is just meet people where they're at and diagnose, you know, whatever the problem is. I think a lot of – you know, if you look at what most people fall prey to, I think there's about four things that most people fall prey to. You know, the first one is overconfidence. So a lot of people are, you know, over-levered or taking on excessively large positions or overtrading or turning as a corollary to this overconfidence. So the first thing that I'm looking for in a portfolio is evidence of this ego or overconfidence. You know, the second thing I'm looking for is attention, which is this tendency for people to confuse ease of recall with probability.
So, you know, if I'm hearing about it a lot then it seems very likely. So I think this happens all the time and it leads to performance chasing and crowded trades and being late, and so we're looking again next for this sort of attention bias, which is are they confusing something being in the news with it being likely? The third thing I'm looking for is conservatism, which is sort of status quo bias. Are they just – are they looking too close to home? Are they ignoring international opportunities? Are they only playing in this sort of small sandbox?
Are they – you know, are they confusing what they know with what's safe or what's desirable? And then the last thing I'm looking for is emotion. You know, are they trading and investing in ways that make them feel good and are emotionally comforting but actually destructive to wealth creation or not? So I'm always on the lookout for things like that. And again, these take a host of concrete shapes in a portfolio, everything from home bias to turning to overly-concentrated positions to, you know, poor entry and exit timing – all of these behavioral ideas have real life portfolio corollaries and I'm looking for these four things inside of a trade history.
Dan Ferris: I see. That is useful. I hope folks will find that useful because I think I just did. [Laughs] I want to tell everybody we're getting towards the end of our time now but I just want to remind everybody that the book is called The Behavioral Investor by Daniel Crosby. I definitely recommend it. I think a lot of this behavioral stuff is just – it tends to be a soup of words and it doesn't – it's not concrete enough, but this book – you cite study after study after study and you focus on the fact that evolution has taught us to be who we are basically. Evolution has made us what we are, and I think that's – for me, that's the important thing, is to note that evolution set us up to do one thing and the stock market requires another.
And you take that topic head on probably better than anybody – I mean I've read a few of these other books and I think you go head on at that better than anyone else, so good for you. [Laughs] Congratulations. And I hope lots of people buy your book.
Daniel Crosby: Yeah. Well, I appreciate it. And I tried at the end of every chapter to have basically a "so what" synopsis, and I think – I've gotten a lot of positive feedback on that, because at the end of the day, like you've done a good job in your questioning, you want to take these studies and these theoretical concepts and go, OK, so what do I do now? How do I make money with this? And I've tried to do that in the book.
Daniel Crosby: Yeah. Yeah, I think you've done it. I mean it's – I would definitely say, you know, do what I haven't done it – read it from beginning to end, because there's a very clear line of argument, and by the time you get to the end you have a lot more confidence that following this path is the right thing to do. So if I could ask you to leave our listener with one thought, what would it be?
Daniel Crosby: I think the thought I'm going to leave you with is that there is hope. [Laughs] There is hope, but the hope is rooted in a clear-eyed understanding of who you are and what your limitations are and what our limitations are as a human family. So I believe in our ability to keep up with and even beat capital markets, but it's all predicated on an understanding, a deep understanding of who we are and how we're wired.
Dan Ferris: Very good. Daniel Crosby, thank you for coming on the program and sharing your insights with us, and I really hope that everybody listening to this reads your book, and I hope you'll come back and talk to us again real soon.
Daniel Crosby: Yeah, thanks so much. All right, thanks so much.
Dan Ferris: OK, it's time for the mailbag. Remember, your feedback is very important to the success of this show, and you can simply e-mail us with a question or a comment to [email protected], [email protected] I read every single one and I try to respond to as many as I can. This week all the feedback was, like, really, really long. [Laughs] They were all really long. So I just took the latest one, the most recent one that I got, because they're all pretty good and they're all really long and they all delve deep into some topic that we've discussed recently. So, let's go here.
This one is from Perry, and Perry lives in Canada somewhere, and he says – he's telling me he doesn't live that far away from me. I'm in the Northwest, he's in British Columbia, and then he says, "Hi, Dan. I can absolutely say that Prem– " Prem Watsa "– and Fairfax Financial are not as well known in Canada as Warren Buffett and Berkshire Hathaway. I have been enjoying the show since you took over, though I do miss Porter –" everybody says that. They say enjoy me but they miss Porter. [Laughs]
He continues, "So with the obligatory suck up out of the way, as you can see from the subject I'm a few episodes behind but I'm making my way through the backlog. I greatly enjoyed your interview with Brian Dalton a few –" this was a few episodes ago "– and while I like the Altius idea –" that's Brian Dalton's company, Altius Minerals "– I'm left with one question that applies to all the royalty streamer firms. The P/E ratios are very high. I use that old rule of thumb that 15 is fairly priced. These all blow well past that – Franco 136 –" and then he just gives me the P/E ratios, the published headline P/E ratios of Franco-Nevada, Sandstorm, Altius, Wheaton and – you know, Franco's 136, Sandstorm is 183, Altius is 106, and Wheaton is 29.
"In the interview, Brian implies that compounding 20% per annum is what makes the high P/E palatable. Why are these worth the price they are? I know you said in the interview that you think Altius should be even 40% higher. Hopefully this question is of general enough interest that you can answer it on a podcast. I am not a subscriber so I'm not sure how small a company you might recommend to your readers," and then he tells me about this company Morien Resources, which is way too small for me. He says, "It seems maybe a little like Altius back in the beginning. I like it and I think it's a solid holding for the long term. All the best, Perry."
OK, so I took this question because this issue of P/E ratio and what these companies are worth is worth thinking about. Look, the value – the intrinsic value of a company is like the intrinsic value of a bond – it's worth the present value today of all the cashflows you receive in the future. One of the things we talked about on the episode with Brian Dalton – and it wasn't that long ago, just look for Brain Dalton. I forget which number it is. But one of the things we talked about is how they own – Altius owns potash royalties, and there's like literally 1,000 – in one case 1,700 – years' worth of potash in these mines.
Like, 1,700 years today without expanding the – you know, they could expand further and it could be 2,000 years today, right? So there's a lot of potash in these mines that Altius owns royalties on. But look – when you do a standard intrinsic value analysis you really don't consider much of the earning power past about 20 or 30 years. In fact, 30 is like much longer than most people go, but this earnings power goes out centuries, [laughs] OK? So you could easily – just based on that one piece of information you could easily see how the current P/E ratio just doesn't come anywhere near valuing these things properly.
There's another reason why P/E ratio doesn't work for these firms. They tend to be valued based on some multiple of royalties, of the royalty revenue, right? So if, for example, Altius – let's say they approximately hit their guidance and do – let's just call it $70 million. Well, the market cap is $530 million – this is Canadian dollars. So $530 million divided by $70 million – yes, I'm doing this as we speak [laughs] is about 7.6 times royalties, and I can tell you for a royalty company that is dirt stinking cheap. That's dirt cheap.
And Altius is arguable cheaper than that because I've assigned – that multiple is just on the royalties and it assigns zero value to the equity portfolio and the whole prospect generation business. So this thing to me, it should liquidate right now for $17 or $18 and it's below $13. It's crazy. And we haven't done the kind of work on Franco, Sandstorm, and Wheaton, the other ones you mentioned, but that's the way you have to think about them, and of course, you know, the mix of streams versus royalties has to be dealt with because, you know, we've talked about the difference between royalties and streams in a previous podcast, but that really is the answer. The answer is if you want to give the sort of convenient sort of model-like – we talked about models earlier in this episode – if you just want to model the valuation quickly you would take a multiple of the royalty revenue, not the headline P/E ratio.
Those headline P/E ratios, we actually don't use them for any – I think they're worthless for every stock. We don't use them at all in Extreme Value. We do our own work and it's based on, you know, the margins and the cashflows and the revenues. It's not just a simple – I don't think you can get away with a simple P/E multiple, you know, model of valuation because there always winds up being so much noise in the "E," the earnings. P/E is price times earnings, and the "E" is so noisy nowadays that you really have to do your own work and build your own model of what the company's real economic output is in terms of cashflow – you know, in terms of their products and then the cashflows that that translates into and arrive at a valuation that way. And what we really do in Extreme Value is even different from that.
What we do is we plug in whatever needs to be plugged in, in terms of revenue, margin, cashflow, etc., and in the future so that we can look at what the price now is in relation to that. In other words, we try to figure out what the current price is saying about the market's expectations, and if the market expects the thing to shrink for 10 years and we expect it to grow, well then we got a bargain and that's basically what Altius looks like today. Great question, Perry. Thank you very much. And, you know, as you point out, you live right up the road. Who knows – maybe we'll see each other.
I'll be in British Columbia, in Vancouver, British Columbia this summer in July at the Sprott Stansberry – I think they're calling it just the "Sprott Event" now. It used to be "Sprott Stansberry." But Steve Sjuggerud will be there, I'll be there and, you know, if you see me there definitely come over and say hi and we'll shake hands. Good question. Thanks very much. That, ladies and gentlemen, is – that's the program.
That's another episode of the Stansberry Investor Hour. Look, it's my privilege to come to you every week and, you know, the numbers suggest that thousands of people are listening every week and I just want to say thank you. OK? So be sure to check out our recently revamped website where you can listen to all of our episodes, see the show transcripts, and you can enter your e-mail there to get all the latest updates so that you know when a new episode has come up, right? Just go to that same address, www.investorhour.com. That's it for this week. Thank you so much. I'll talk to you next week. Bye-bye.
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