almost 3 years ago • 6 mins
On this edition of Insights, Andrew Rummer sat down with Dr Bradford Cornell to discuss his theory of the “big market delusion” and how it can affect stocks in exciting, fast-growing sectors. Brad is emeritus professor of economics and finance at UCLA and an advisor to Cornell Capital Group, his son’s investment firm.
Last year, Brad and Aswath Damodaran, another academic, published a paper outlining their theory of the “big market delusion” and a few weeks ago he published some updated research on the same theme but looking specifically at the electric vehicle industry.
When picking stocks, plenty of people will understandably look to companies operating in fast-growing markets that promise to be huge in future – such as electric vehicles or green energy. The “big market delusion” however, argues that the vast majority of such companies will end up failing, so investors should be very careful. Basically, just because a market will be big in future it doesn’t necessarily mean that companies operating in that market will go on to make good investments.
Brad’s research looked at the ecommerce boom of the 1990s, the online advertising boom over the past five or 10 years, and the more recent booms in North American cannabis stocks. In each case he found markets that massively increased in value, but where companies struggled to capture that value and pass it onto investors.
And Brad feels so strongly about this he’s even willing to short – that is bet on declines in – shares of companies in some of the hottest sectors at the moment. Here’s a transcript of the interview, which started with Brad outlining the problem at the heart of the so-called “big market delusion”:
Bradford Cornell: When investors get enthusiastic about big markets, all the companies in that industry tend to rise. And that leads to what Professor Damodaran and I called the "big market delusion". It's a fallacy of composition. That if they're all competitors, they can't all do well. And investors have to be careful about that.
Here's the problem: all the companies are priced as if they're going to be winners. A few will be big winners – will be Amazon. If you think you can pick the next Amazon from the group, go ahead and try. But if you were to buy all of them, and they're all priced to be winners, and only one will win, you're going to lose on all but the winners. And if you try to pick the big winner, you're likely to end up with being wrong and being stuck with a loser. I mean, one great example of this, if we stick with the automotive industry for a moment – that was a fantastic innovation around the turn of the century. And over the next 100 years in the United States, there were over a thousand automobile companies started. And by the year 2000, there were basically three left: Ford, GM, and Chrysler. And all the other 997 had failed in a big market.
Another one is the airline industry. Another fantastic innovation. But as Warren Buffett says, had he been around at Kitty Hawk, he would have shot down the Wright brothers. They've cost investors so much money. Virtually all airlines have gone bankrupt or merged into other airlines which in turn went bankrupt.
Andrew Rummer: Where are you currently seeing these “big market delusions” forming?
Brad: Well, electric vehicles is certainly one. I've looked at that one very carefully. Another one is probably green energy. You know, hydrogen fuels, battery companies – these are exciting technologies, but not everyone can benefit. And there's gonna be a couple winners, but there's gonna be a lot of losers.
Andrew: But yet plenty of investors are desperate to find the new Amazon or the new Google. Are you saying that they're wrong to approach investing in this way?
Brad: Well, wrong might be too strong – but they're certainly playing a very dangerous game. And let me use electric vehicles – because it's more current – as an example. You have not only Tesla, but a bunch of startups – like NIO, and Fisker, and Lucid, and many others – all being priced as if they're going to be big winners. And you also have the traditional automakers like VW, GM, Ford, etc jumping whenever they say they're going to do something in electric vehicles – and not everyone can benefit that way. So that is a significant problem for investors. If everything's priced like a winner, they're going to end up overpaying for 10 companies. And then the one Amazon may emerge, but if they didn't pick it, they're going to lose on all the other 10.
Andrew: So how do you take your academic research and apply it to your own investments? Do you just shy away from all new technologies?
Brad: I tend to. Not all, but let's take the electric vehicle ones. I'm actually looking to get short some of them. I think that some are way overhyped: NIO being an example. And even Tesla. Tesla is priced as if it's going to have margins like Porsche and sales like Toyota. And I just think the market's too competitive for that. I think we're seeing VW really start to hurt Tesla. Toyota is going to do things, all these new startups, the Chinese companies, and so forth. So I think your best chance for profit may very well be on the short side.
Andrew: One of the other conclusions from your research I found interesting is that while these kinds of market bubbles can harm investors who jump in, they can be beneficial for society as a whole – so governments and regulators shouldn't worry too much about them. Can you talk us through those conclusions a litte?
Brad: Well, there's a very fundamental problem that economists have pointed to for decades, which is there's not enough incentive to do fundamental new research. And the reason is that the person doing the research, if it fails, takes all the losses, and if it succeeds, doesn't get all the gains – because new competitors can enter and syphon off some of the gains. So there tends to be underinvestment in fundamental new technology, and overenthusiasm and bubbles can offset that. Think back to the 2000 internet bubble. Yes, that was a big problem for a lot of investors: most of the companies went bankrupt and investors got wiped out in that situation. But the net social effect was to attract capital to the internet, which has been a huge social benefit. So from a social point of view, bubbles may not be a bad thing, even if they are for the investors who pick the wrong companies to invest in.
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