Just One Thing: 'Skill and Information Are Your Remedies'
George Gilder wrote an article with this jarring title: "The Outsider Trading Scandal." Why would he use "outsider" when we know that trading scandals almost always involve insiders?
The article is one of a dozen published in the book, "Just One Thing: Twelve of the World's Best Investors Reveal the One Strategy You Can't Overlook," which was compiled and edited by John Mauldin. Getting the single best idea from a dozen accomplished investors was the premise for Mauldin.
Gilder is a prolific writer in the political and investment arenas, as well as an influential technology writer and publisher. In his 1981 book, "Wealth and Poverty," he made the case for supply-side economics for the Ronald Reagan administration. According to his bio at the Discovery Institute, he is currently chairman of Gilder Publishing LLC, a co-founder of Discovery Institute and a senior fellow of the Center on Wealth, Poverty and Morality.
He begins his article by reporting on two technical analysts, Ralph Bloch and Jim Stack, who made a powerful argument that "the best and most objective guidance to the future movement of the markets comes from the market itself." In other words, watch the stock charts because they capture all the knowledge available to investors. By implication, the information that comes from companies and experts must be biased by subjectivity and self-interest.
But Gilder isn't having any of that. He wrote:
"Only rarely does anyone point out that without fundamentals--without close and necessarily subjective scrutiny of the actual performance and potential of each company--markets would contain virtually no information at all. Markets would slouch through the kind of random walk that Burton Malkiel and others have famously described. In a random world, luck would dominate skill. Like casinos or lotteries, markets would fall to the inexorable law of gambler's ruin."
He went on to point out that investors should know an economy is not a casino or lottery, nor a physical/material system--it is a world of information. Thus, he said, "In markets, the winners are the people with the best information, mostly inside information."
Returning to the subject of technical analysis, Gilder wrote:
"Outsiders doing technical analysis can occasionally be effective, particularly when guided and seasoned by an intuitive or stealthy mastery of fundamentals. But technical analysis is essentially parasitic. It is outside information. For its validity, it depends on the fundamental judgments of insiders and the insights of knowledgeable analysts who appraise the DNA of companies: their management, their financial data, and their technological endowments."
In other words, markets are ultimately driven not by the fickleness of investors, but by the forces of supply and demand, as well as what the author calls "the realities of finance" and a company's execution.
So if markets are driven by these fundamental forces, why do we have the madness of crowds, the bubbles that inevitably burst and other erratic behavior. Gilder wrote, "A key reason is the outsider trading scandal".
Specifically, that happens because laws governing public companies prevent them from releasing "materially significant news unless it is published simultaneously to the world." That's a rule with good intentions, one that levels the playing field between outside investors and inside investors.
But, Gilder argued, such laws actually minimize how much real information is received by the public. He said, "Less information means increased volatility and more vulnerability to outside events. With the entire field of information about companies a regulated arena, information does not bubble up from firms spontaneously in raw and ambiguous form with executives and engineers freely expressing their views and even investing on the basis of them."
He also argued that these laws do not prevent illegal insider trading; people with criminal intent will continue to do what they do.
The most important effect of those laws is to stop the flow of inside information that would allow investors to get real insight about matters such as the progress of technological developments, research and development and daily sales data. Instead, the little information that is available from companies comes out only after it has been vetted by public relations practitioners and lawyers. As Gilder scathingly put it, "The resulting press releases are mostly bombast and bafflegab, zero-entropy documents teetering over a bay of safe-harbor statements often larger than the release itself."
Because of these restrictions, the biggest winners are executives in conglomerates, people such as Warren Buffett (Trades, Portfolio) at Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) and (at the time) Jeffrey Immelt of General Electric (NYSE:GE). Also in that group are venture capitalists who have valuable inside information about the companies they are taking public. Conglomerate executives and venture capitalists have access to legal inside information that is not available to other investors.
Where insider information is restricted, investors become vulnerable to outside noise. Gilder wrote, "Mostly working in the dark, investors become paranoid and jump at every movement in the shadows. They debate the implicit punctuation in speeches by Alan Greenspan." The author even mocked himself a bit, saying, "They even speculate on what will be the next company deemed to hold an 'ascendant technology' by the Gilder Technology Report."
He concluded his article with this advice: "The key rule for investors is to ignore the outside noise and focus on acquiring real, fundamental knowledge about companies. The fundamentals will ultimately prevail."
And, as someone with a pulse on new technology, he went on to note that investors were being aided by a new generation of information companies that are leveling the field to some degree.
Conclusion
Outsider trading is what happens when investors are starved of information about what's going on inside publicly traded companies. According to Gilder, that starvation is an unintended consequence of government-enforced laws meant to level the playing field for all investors, insiders and outsiders alike.
Scandal comes in the form of uninformed investing, where investors are all too frequently pulled into bubbles and then lose much wealth because of busts. In less acute cases, it means investors cannot optimize their decisions because they lack key information.
To some extent, this is a technology company problem; in more traditional fields like retailing and manufacturing, innovation is less of a factor and forecasts are more reliable. Also, given the technology factor, Gilder does not address the fact that most companies in that arena depend on secrecy to get a toehold in the market and compete against established rivals.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
This article first appeared on GuruFocus.
