Cheapest Price vs Best Bet
Intrinsic to most good investment processes, is a process for working out how much to commit to each bet. As Buffet says, ‘Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble’. A corollary for most investors is that if risk or uncertainty is high, we should be more inclined to bring the thimble. A conservative process would dictate that we invest less absolute dollars at point A than we would be prepared to do at point C, by which time our overall knowledge of the company is much greater.
If we take this approach, then we might find that there are actually better opportunities to maximise profit by paying a higher price. Buying two shares that double makes the same absolute amount of money as buying one share that triples. But on a risk adjusted basis, the trade might be considered more profitable. If the outlook for the company has improved at a faster rate than the share price, the shares might actually be “cheaper” at the higher price.
Of course I can already hear you say – if the news is improving, won’t this get priced in? Not necessarily. The essence of the Hype Cycle model is that there are times when good news gets priced in too quickly and times when it gets priced too slowly. We should wait for this second phase where we have information that is too slow to be priced by the market. It is the modern day equivalent of not shooting until you can see the whites of their eyes.
In summary, the model acts as both an explanation of market behaviour and a moderator of our own behaviour. A strategy that waits until C might miss some good opportunities at A. But it will avoid the losses from buying at B. By distinguishing between the emotions and the fundamentals driving the share price at C, it will help in bringing the bucket rather than the thimble to this later trade.
In the period post the dotcom bubble, point C often offered better fundamentals at similar prices relative to point A. In other cases fundamentals were similar but prices much cheaper. But most encouragingly, in many cases both fundamentals and share prices were significantly better at point C than at point A.
Like all models, the Hype Cycle is not perfect. But when applied judiciously, it should be useful.