Markets turn financial capital into physical capital.
That is my favorite definition of finance. I heard it years ago when Wenger was interviewed on Invest Like The Best.
The quote continues:
Finance bridges the fact that people need to borrow from the future to work on something today which will result in physical capital in the future which acts as the collateral for the loan or equity up front.
I like this because it explains the economic purpose and mechanism of finance simply, yet abstractly. It is without prejudice to conventional objects of its abstraction like banks and funds on the supply side of capital or companies on the demand side. These objects can be substituted with other social constructs in ensuing centuries and the definition will hold.
If you listen to the interview, Wenger adds an opinion to his definition:
Markets have been the most efficient way to allocate financial capital.
I’m publishing this essay in 2021. Let me tell you that Wenger’s opinion feels pretty shaky. GME and DOGE are the tips of the absurdity spear. But since I agree with him (see Dinosaur Markets), I have felt pressure to examine my own model of how markets work. The role of finance is clear but the practice of it, investing, is far more art than science as textbooks might lure you to believe. It would be a grave omission for the next generation of textbooks to not discuss reflexivity, for example. It’s not that conventional definitions of finance are broken, it’s how two-dimensional the process is described. The returns are presented as if they mechanically spit out of a wood chipper. In reality, the wood chipper looks like it can stand up and beg more trees to jump inside it.
That sentient woodchipper is of course the market. The problem isn’t with markets. It’s with your formative beliefs about markets. Markets are an emergent system where the actors learn, act, and get feedback. Repeat loop. They all do this at the same time. That means that some of their lessons are artifacts of their own behavior. It’s like taking your pulse with your thumb, forgetting that it has a faint pulse of its own. Markets are layers of sedimentary behavior, compressing at an increasing rate, on top of a core finance function. That increasing rate scales with the modern speed of information creation and spread.
[A common criticism of crypto is that it’s just reinventing well-functioning features of conventional finance. So what? That observation is secondary to the speed at which it is doing so. It reminds me of when I moved from equities trading in 2005 to commodities. When I started on the NYMEX, the underlying was still not electronic! Once the market began to modernize, it had the advantage of leapfrogging many of the inefficiencies equity markets might have worked through as they moved to the screens.]
The layers of market sediment are sufficiently thick, and the core of the finance function is so sufficiently buried, that a focus on fundamentals will leave you feeling like markets are astrology. Prices feel governed by tides of celestial sentiment rather than waves from a named storm or measurable weather pattern. I don’t think this is new. My feeling is that it was always this way, but since there were fewer layers of learned-Vizzini sediment, the textbook illusion that prices are closely tied to fundamentals wasn’t as visibly challenged.
This post is superficially about the danger of believing the textbook-style investing delusion. But it offers a framework that extends the textbook views in ways that better align the objective (investing effectively) with what is required (focus on the correct inputs which are, sometimes, but rarely fundamental).
Regular readers know the tyranny of my trading experience means everything looks like an options nail. No judgment if you turn back, but I promise no math.
The Elements Of Value
Let’s re-purpose the concepts of intrinsic and extrinsic value. You were warned.
The financial definition of “intrinsic value” depends on context. In options, it is the amount the contract is in-the-money. The difference between the stock price and the strike price. For an out-of-the-money option, the intrinsic value is zero.
A comparable idea in stock valuation might be book value. That’s the value of a business if you liquidated all its assets today and satisfied its liabilities. It is a simple accounting value of a company. It is unconcerned with the asset’s ability to earn money. If Elon Musk started a THC-infused lemonade stand its book value would be comprised of the street value of the THC syrup, a basket of lemons, and the Martian goblets he’d serve drinks in. Assume he’s the only employee and plans to sell 5 drinks a day on the way to the office out of the back of his cybertruck. Let’s be generous and assume the lemons are organic. The accounting value of this company is like eighty-six bucks. The equity will trade for $11 billion. So book value is $86. Equity value, $11B. If this was like options world, we’d say the intrinsic is $86. That’s what you’d get for the assets today.
This is not a helpful use of the term “intrinsic value” because it ignores the earnings power of the assets in the hands of the right operator. In reality, equity is the residual claim on a business once all liabilities have been met. The equity owner has unbounded upside in exchange for being the most subordinate in the cap structure. So equity itself looks like an option.
Luckily, there is a notion of intrinsic value that applies to stocks but is not so conservative that it would lead us to believe that anything Elon Musk tried to do would only be worth $86. We can borrow Warren Buffet’s version of intrinsic. The exact details don’t matter for our purposes (this feels irreverent to say since it’s some investors’ sacred cow, but if I’m not giving away too much, it only gets more irreverent from here. Sorry, not sorry). The gist of it is some measure of a stock’s expected future earnings discounted for risk and time value of money. More compactly, intrinsic value is a company’s earnings power times a multiple.
The key to this definition is that it smushes together a very traditional definition of intrinsic (book) value with a forward-looking estimate of earnings. But it’s a conservative estimate. Nothing that would turn your mood ring red or even get Elon out of bed in the morning.
I think the intrinsic value of an asset is what its worth in and of itself. From owning it for, for its own sake. I think a good way to test this is to just ask yourself, for any asset or anything whatever it is, what would be the most that you would pay for it if you were stuck with it forever. [Assume] you can bequeath it to other people when you die and so forth, but you’re stuck with it as is. You can’t ever translate it into cash in a market. What is the most you would pay for that thing? That is my test for what intrinsic value is.
He gives the example of a home. Even if you did not think it would go up in value, it still has consumption value since it saves you rent. You could also rent it out. In both cases, the intrinsic value will look something like Buffet’s definition. The sum of many years rent discounted for some costs.
Before moving on, what have we established?
- Stocks themselves are options. You can pretend they are zero-strike calls or calls struck at book value. It doesn’t matter, they are options.
- Our definition of intrinsic value is a conservative sum of future cash flows
- Intrinsic value is a property of any asset. It can be zero if nobody is willing to pay even a scrap value for it. [Craigslist and Ebay raised the intrinsic value of many items indirectly by lowering the cost to exchange them. It raised intrinsic by lowering the strike price.]
Borrowing from options-land, extrinsic value is the “it could happen” premium. It’s driven mechanically by 2 inputs: time and volatility. All else equal, a 1-year option is worth more than a 1-week option. Similarly, if the underlying stock has the potential to change the world in the next year, perhaps it will cure cancer, its volatility will be high since its market is every human. Or it might fail all drug trials and be a zero. The range of possibilities gives the options more value than the options on, say, a giant widget company whose business has predictable cash flows.
But, remember we are moving from the world of financial options to thinking of the companies themselves as options. To do this, we are going to decompose extrinsic value into 2 components: imagination and liquidity premiums.
Let’s continue with the drug company.
We already assigned an intrinsic value that incorporated an expectation of future cash flows. Unfortunately, estimating any future cash flows from this drug company conservatively is impossible. No, this is a company whose value is made up solely of possibility. The probability-weighted forking paths that underpin its traded value feels…well, not like our definition of intrinsic. The discrepancy traces itself back to the fact that this particular company is less a business and more just a black box holding a far out-of-the-money call option. Yes, all equity above book value is an option but this one feels entirely comprised of time and volatility value.
This company is what AMZN was in 1998, braced on the cusp of a connected, online world. The entire value of the company was extrinsic. The implied volatility of AMZN back then was regularly in the 100-200% range, a straightforward reflection of justified qualitative uncertainty. Was it different this time? [narrator: it was]
So we can say that certain companies have option value above and beyond our modestly padded definition of intrinsic value. Is TSLA a car company, battery company, software company, self-driving car company, solar company? The market is assigning a massive premium above what any multiple-on-grounded-earnings could furnish. Not unlike AMZN over 20 years ago. This type of premium is again extrinsic. We are going to call it Imagination Extrinsic to a) honor its visionary nature and b) to distinguish it from another component of extrinsic: liquidity.
@Jesse_Livermore’s work refers to an idea he calls “transactional value”. It is the value that permits you to pay more than intrinsic value for an asset because you know you could sell it back into a liquid market.
Here’s Jesse parsing intrinsic value from transactional value:
The intrinsic value of equities would be the cash flow stream of the equities themselves, which you can collect and they belong to you and you can spend them and do whatever you want with them.
The transactional value would be the value that comes from the fact that there’s this “network of confidence” in the market, that people have been doing this for hundreds of years and we know that when you wake up tomorrow, the S&P is not going to be at 500. It’s going to be near where it was yesterday and people are kind of anchored to where its price is…You can basically take all your money, 100% of it, and put it into the stock market and know that you’ll be able to get a lot of that out anytime you need to. That’s the transactional value, which is the premium.
The idea that liquidity commands a premium is not new. If you have any money in a savings account today, you are paying a liquidity premium in the form of negative real interest rates. The treasury market discounts off-the-run securities because they are thinly traded even though they mature to the same value as their on-the-run counterparts. But I don’t want to dismiss Jesse’s notion of transactional value because it’s not novel. His expression of it is illuminating. For example, currency is made entirely of transactional value. The fact that we can rely on it to trade warrants a premium entirely out of proportion to the value of paper that represents it.
We will call this component of premium: Liquidity Extrinsic
Let’s take inventory. Asset values look like options composed of:
- intrinsic value: a conservative sum of an asset’s future cash flows or consumption value
- extrinsic value: the premium in excess of intrinsic comprised of:
- imagination extrinsic: a premium derived from hard-to-approximate, low probability states of the world that presumably benefit the asset
- liquidity extrinsic: a premium built on “networks of confidence” which re-assure that you can convert an asset to cash. Lacking this feature an asset would burden your liquidity profile
- imagination extrinsic: a premium derived from hard-to-approximate, low probability states of the world that presumably benefit the asset
Asset Value = Intrinsic + (Imagination Extrinsic + Liquidity Extrinsic)
The Perspective Of The Marginal Buyer
With our elements defined, we can now discuss setting the price for an asset. Price is a prerequisite for liquidity. Think of it this way, the value of an asset, for example, shelter exists independent of price. If there is zero bid for your house, but it keeps you dry, it still has value to you. Pricing is what allows an asset to find liquidity. Price is just the bridge between buyer and seller. A volatile market, with prices ripping in every direction without continuity, is illiquid by definition.
The question of who sets the price is really “who gives the asset liquidity?” Let’s imagine a hypothetical order book. We will fill in the bid stack with a taxonomy of players, with decreasing bid price, just like a real order book.
Mapping the bid stack to the elements of value
Let’s map the investor type to the liquidity they provide. We will start with the lowest bid and work our way to the highest.
- Distressed investors
Focus on the book value portion of intrinsic. Distressed investors are using the assets comprising the book value as collateral for their liquidity.
- Value investors
Focus on the full intrinsic value. Value investors are using the earnings power of the company’s management + the assets as a basis for their liquidity
- Growth investors
Focus on imagination extrinsic. Growth investors are willing to speculate on future paths that may lie over the hills. Their liquidity underwrites the potential for an unchallenged blue ocean.
- Magical Thinking Investors
These investors are somewhere in between LSD levels of imagination and playing hot potato. The entire bid is contingent on the belief that someone else might pay more. It’s pure liquidity extrinsic. It’s GME. It’s DOGE. It’s intentionally buying ZOOM instead of ZM or SIGL when Signal is actually private.
This is not entirely ridiculous. Holding currency for its liquidity value, can be thought of as magical thinking. This is not derogatory. If you believe unpegged fiat is a “shared story” then it’s a monument to human cooperation. (Of course, trying to pay your taxes in anything other than USD will lead to knocks on your door by men in ill-fitting suits and sunglasses…so maybe I’m discounting military coercion too much.)
Liquidity Extrinsic and The Bid Stack
- Liquidity premiums can exist anywhere and everywhere across the bid stack.
Faith in liquidity increases the demand for an asset since it is easily convertible back to the fiat your obligations are denominated in. If you did not trust liquidity, you would need to hold more fiat in reserve just in case. This would reduce your demand for assets.
- Liquidity extrinsic becomes a higher proportion of the extrinsic as you ascend the stack.
We already saw that the marginal “magical thinking” bid is entirely made of liquidity premium. It can be reasonable as in the case of fiat currency, or wildly speculative like Black Lotus Magic cards. What happens at the distressed end of the stack where there is no liquidity extrinsic?
This is the zone where fundamentals are fully central. In a recent interview on Corey Hoffstein’s Flirting With Models, volatility manager Cem Karsan explains:
In the very long term, all that matters is cash flows. At some point you’re gonna have a liquidity crisis and when the liquidity is not available, companies have to create their own liquidity and that’s where fundamentals matter…they matter, to the extent that they are necessary for purchasing their own stock or buying other companies.
I’ve used this analogy before, it’s kind of hokey, but I can’t think of a better one. If you’re on an airplane, 30,000 feet off the ground, that 30,000 feet off the ground is the valuation gap. Valuations are really high, but those engines are firing. Are you worried up in that plane about the valuations or are you worried about the speed and trajectory of where you’re going, based on the engines, based on the flows? The flows are what matter for where you’re going.
But when all of a sudden those engines go off, how far off the ground you are is all that matters. And so, [valuation] is more of a risk management tool, and ultimately it really matters when you have a liquidity crisis. It also matters if rates were to go back to 8, 9, 10%. Something crazy again, where nobody can borrow money, and there is no liquidity. Cash flows are all that matters again and we have a world where fundamentals are all that matters. So I want to be clear. It’s not that fundamentals don’t matter at all, it’s that they don’t matter in a world of massive liquidity.
Read the boldfaced words again. You should be uneasy. The textbooks, with their dogmatic models of DCF and valuation techniques, appear to be preaching a style of investing that gets lost in the liquidity. We’re going to need a closer look.
- We have defined our elements of value:
- Intrinsic (this is not just book value but includes a sum of reasonably visible future cash flows)
- Imagination Extrinsic and Liquidity Extrinsic
- We have identified our “bid stack” of distressed, value, growth, and “magical thinking” investors
- We have mapped the bid stack to the elements of value
- We know that as we get to higher marginal bids, liquidity premiums dominate the price.
How An Asset Flows Through Tiers Of The Bid Stack
The liquidity an asset receives depends on which class of marginal buyer is setting the price. Flows are a response to how the top bid perceives changes in the element of value they are focused on.
We’ll look at 2 examples.
1. When Intrinsic Value Goes Up, And The Stock Falls
If distressed or value investors represent a stock’s marginal liquidity there is a limit to how lofty the valuation can get. While we have allowed our version of intrinsic value to include a multiple that multiple has a speed limit. The limit isn’t a hard number on a street sign, but something on the order of the inverse of the discount rate which accounts for both risk and cost of money. Even if we use a 0% interest rate, there’s still a risk premium. If we are aggressive and say that’s only 3% we are talking about the intrinsic multiple in the realm of 33x. The exact number doesn’t matter, but subjectively speaking, this would be on the expensive side of intrinsic.
To break into a higher gear of valuations, the marginal bid has to come from imagination extrinsic focused investors. The multiple that rests on is effectively unbounded (AMZN traded at egregious multiples in its early years and in hindsight they were not egregious enough). But this also works in reverse. If a stock’s imagination extrinsic is offensively large, its success can actually lead to poor returns.
The intrinsic value increases as it makes profits, but its extrinsic value declines. The number of forked paths ahead of it evaporates faster than its fundamentals could ever make up for. It’s the same feeling you’d have if you bought a put option on a stock, and lost money even if the stock fell. You overpaid for the extrinsic which receded more than stock’s decline.
Somebody said to me once, a smarter, older business guy, a board member that I know is like, “If you have a fast blind growth kind of company, the last thing you want to do is really get revenue. Once you get revenue, the last thing you want to do is get profit.”
I was younger then. I didn’t understand what he was saying. And he was just like, “You don’t understand. There’s multiples that they sell at. And once there’s EBITDA, nobody cares.” And now you’re getting multiples of EBITDA.
He’s like, “I want multiples of shit. I want multiples of magic.” And I asked, “Why?”
He goes, “Because once people have something they can poke holes at, then you have a really big problem there. Then you have to play defense.” And everybody knows that once somebody casts a stone and there’s a crack in the window, playing defense becomes really, really difficult. If you’re throwing a stone at Space X or Tesla, it’s like, all right, well go ahead. What are you throwing it at? There’s nothing to throw it at. It’s not there yet.
Your marginal liquidity rolled down from a price invariant buyer to one that uses Excel to justify its bid.
2. When Liquidity Is The Only Element Of Value
Suppose you think the upcoming earnings matter. Your tacit assumption is that the best bid cares about intrinsic or possibly imagination extrinsic. You must believe value and/or growth investors are in control. It’s comforting to think so. Although it’s not perfectly clear whether that’s reality. It could also be the case, that enough people think that value and growth investors are driving the flows, so it’s safe to focus on what they might focus on. That world would not look different if you just observed news and prices. But it is different. It underestimates how much liquidity itself drives price.
Recall how DOGE and GME were being driven entirely by liquidity. Here’s Alameda’s Sam Bankman-Fried on The Odd Lots podcast:
A beautiful moment was the moment that Robin Hood banned buying a Gamestop. [It was beautiful] because of what happened next…[when] GameStop crashed because they could only sell [and people] couldn’t buy but they had money. Instead they bought what is, in retrospect, the only possible answer to this question, as soon as you hear it you’re like “Oh, of course that’s what they bought”.
They bought Doge.
So, as soon as Gamestop started crashing Dogecoin 10x’d. And it’s like absolutely beautiful [because] Gamestop and Dogecoin are like very, very similar products.
As you realize that liquidity alone can drive value, it starts to feel that it totally swamps the sensible stuff that textbooks talk about. One day business considerations are driving price, the next day WSB shows up. Even if they help you it’s unnerving. Like making money on a trading error.
Other favorite examples of liquidity being the sole driver of value:
- Archegos levered longs that imploded in March 2021. Viacom dropped >50% from its high and never recovered.
- Amaranth blew up on a long March/April gas futures bet, which ultimately collapsed from over $3 to zero.
There is a commonality between these trades. The peak prices were built entirely on the outsize liquidity it required to drive them there. But liquidity is an unpredictable mistress. The legend I’ve heard is Brian Hunter offered to sell the spread back to Centaurus, pleading that he would offer a discount from the $3 price.
Allegedly Centaurus founder John Arnold bid him a mere 50 cents. Offended, Hunter pleaded, “but it’s trading $3!”
Arnold replied: “Because you put it there. It’s worth $.50”
[This is all lore from my cheap seat…if anyone knows the real story, I’d love to update this post with it!]
If liquidity is driving price, but people are talking about fundamentals, it’s like being on a plane to Calgary but everyone’s talking about how fun it’s going to be when we touch down in Vegas. Somebody packed the wrong clothes.
The Most Practical Takeaway: Know Your Game
These 2 examples highlight regime changes when the category of marginal buyer changes and with it the focus on intrinsic or extrinsic. If you are playing the extrinsic game, your dashboard needs to be concerned with liquidity and flows. Momentum investors don’t cite fundamentals. Vol traders might not even know what the underlying even does. Their inputs match the game they are playing.
Returning to Cem Karsans interview:
[If] you’re betting on something that doesn’t, in the short term, have anything to do with the outcome, you are in a really dangerous situation…Until the liquidity situation changes, other than the fact that other participants are playing the same game and affecting those flows, [fundamentamentals are] not what’s ultimately driving price.
Ask yourself, is the asset moving from one part of the bid stack to another? You may have started shorting GME last year based on valuations but once it turned into a virus you were still using a telescope when you needed a microscope. There’s a reason famous short-sellers like Chanos or Cohodes are not known for playing the valuation game from the short side. Instead, they are hunting for frauds. The reason is there is no limit to arbitrage on the short-side (see Shorting In The Time of ShitCos) , so they are playing a game with a catalyst. With a visible horizon for price and truth to converge.
How about investors who drift into calling bubbles? If you want to profit from bubbles imploding, you must identify when the focus of an asset moves from its extrinsic to its intrinsic. From our framework, it’s clear that it is a question of liquidity. Many investors already understand this leading to an obsession with macroeconomics and central bank balance sheets. [When I read about those topics I feel as overwhelmed as when I first started learning options. As a 21-year old, I’d need to stop every few moments, “ok, so if I short a put, and puts make money when stocks go down, then I must be…long!”. Nowadays it’s, “ok, so if the Fed injects liquidity, it’s balance sheet decreases. Wait, I mean increases. Wait…ahhh, make it stop!” This hasn’t stopped a bubble in macro gurus…I guess the tourists who would have went to Vegas in 2020 found a new club to hit.] Making money from bubbles is diabolically difficult even if you become an expert in M2 or Japan. There are creative approaches that do not take them head on.
The main point is to match your tools and horizon to your game.
Between stock valuations, crypto returns, and a headlong embrace of risk within months of an economy-halting pandemic, the role of finance as manifested by investing looks like a farce. Market watchers are asking themselves:
- Is the bulk of what we are taught about investing poorly matched for the timelines we buy and sell on?
- Is a 5 or even 10-year track record noise if liquidity regimes delay any verdicts? It feels like the betting windows at the track have never been busier, but we never see the result of a race.
As I’ve listened to interviews, read, and thought about what the hell is happening, I’ve come to believe that markets are not absurd. It’s our illusions about how tidy they are which is absurd. By asking ourselves meta-question about who the marginal buyer is and what their focus is we can tranche the investing world into different games. Not every tranche is driven by the same inputs. Some layers in the stack are concerned with extrinsic and others intrinsic.
Surviving within each tranche demands its own set of tools to furnish bids. To give liquidity to the assets it targets. On the low end, cash flows matter because they create their own liquidity. On the high end, external liquidity drives most of the value. Imagine a new set of greeks for this segment. ∂ Extrinsic / ∂ Liquidity. The second derivative of that sensitivity would tell you that the sensitivity itself is changing. That’s what happens as you move from one tier of the stack to the next.
The conventional finance education omits so much of how the practice of investing manifests. Ultimately, your goal is to have the outcomes of your bets have something to do with your rationale. To do this, go ahead, read the glossary of corporate finance terms. Finance is totally real. But skip the investing sections. They present the practice of finance as being built up from the glossary. Instead, bind Matt Levine’s daily columns into a book, and work backward from the fact that markets are made of humans. Investing is about behavior and that is closer to horoscopes than balance sheets.