E=MC^2

Jogging in Zürich not long ago, I passed by the ETH, where Albert Einstein studied between 1896 and 1900 before leaving the school to become a patent clerk in Bern.

Five years later, during his miracle year, he gave birth to the general theory of relativity and the most famous formula of them all: E=MC^2

The formula’s beauty lies in its simplicity. It summarizes the universe with three letters that state that the total energy of a system equals its mass times the speed of light squared. 

What does it have to do with finance you may ask? Nothing and everything at the same time.

For hundreds of years, there was an immutable law of physics that was never challenged: that in any reaction occurring in the Universe, mass was conserved. That no matter what you put in, what reacted, and what came out, the sum of what you began with and the sum of what you ended with would be equal. But under the laws of special relativity, mass simply couldn't be the ultimate conserved quantity, since different observers would disagree about what the energy of a system was.

In a social information digesting system like a market, the same logic applies. For every buyer there must be a seller. Both actors can have access to the same information but must interpret it differently from their own relative perspective to strike a deal. Both can have access to the same data and news, but eventually focus on different bits of information to end up at the opposite side of the trade.

In markets, price discovery mechanisms are information digestion processes at work. Information is the fuel, the energy contained in situation. Price movements are the visible of energy at work in a stock and respond to news instantaneously. In physics, energy is quantity to perform or to heat an object. Applied to stocks, it could be the potential size of the move embedded in a stock situation, which itself reflects the size of an information gap discovered by the market.

Price movements can of course overshoot and undershoot. Prices are after all just a probabilistic function of the proportional values of all the possible future events. Such events are not linear. Small changes can make a big difference to either the value or such and such event happening, the same way a small leak can sink a big ship. So unlike the speed of light, which is a constant, C is change. Change is also the only constant in the universe and in the market.

As per Shannon’s information theory, what is known in the stock market is worthless. It’s either priced in or not. It is always at the mercy of the random, the unexpected and the unknown. No one knows everything in the stock market. Our ape brains cannot compute all of the information in the world or nobody has access to all of the information in the world. Even if it did, it would have to also predict its own future, which of course in an evolutive process like a market would result in the death of that market. If a well informed robot were to win all the time, it would become too big and too dominating a force for its own good. Because change is what gives life to markets, the robot will be faced with a conflicting choice between survival and winning, between predicting change and acting for the status quo.

Contrarily to physics, change or information is not just a fact when computed in a human brain, but also a perception with its own emotional footprint. People react differently to different things based on their own personal experience, imperfect knowledge and circumstances. This explains why assets can be temporarily mispriced. Panics, neglected securities, distressed sellers or buyers, bubbles, etc. are all familiar

behavioral patterns that can create major temporary value anomalies. 

So if information gaps can be the E, C is change, M could be value or the difference between what an asset is actually worth and its price. For contrarily to Efficient Market Theory, prices are never in equilibrium. They cannot be. Because they predict the future, whose odds are never the same and always change, but also because no one knows everything and even they were to know, emotions would come into play.

The introduction of emotions in the equation adds a dimension that is obviously absent of modern physics or the laws of thermodynamics and probably mean that the light or the change can be both factual change (based on the laws of supply and demand and ruled by economics) and perception change (ruled by human nature). Social science has to deal with human nature. Facts (fundamentals) can be altered by perceptions and perceptions will also be influenced by facts. The mathematical and rational laws of supply and demand will have to also take account the more irrational and fractal laws of human nature. For our formula, this is only a tiny twist, which can be taken into account into the type of change we shall be looking at, either fundamental changes or perception changes.

It comes that the energy contained in a stock is equal to its value (the gap between what the asset is worth from an economic standpoint and its price/cost) times the compounding factor of future fundamental changes times the compounding factor of future perception changes.

Let’s illustrate.

I bought Eurofins, a European testing lab company, back in 2010. At the time, the stock was trading at 8x EBITDA, when its peers commanded 12x. The company had overexpanded and overleveraged just as the financial crisis hit. Its labs take two years to break even and there the market was looking at a leveraged cash burning business facing a rough patch. Yet change was in the offing. The EU had just passed a regulation set to boost the company’s business (REACH) and other regulations were in the pipe to better inform consumers on the quality of their foods. It was easy to see that the shares could appreciate significantly when the market start realizing that the profitability squeeze of start up costs temporary and that the losses would soon turn into profit (fundamental change), but also that the regulatory changes would drive a decent mid term growth and perception change. As it happened the stock value gap was eventually filled producing a rerating from 8x to 12x EBITDA between 2010 and 2012, as its start up labs started turning a profit pushing the stock from EUR 35 to north EUR 100. I thought I was a genius and I took my profit. Little did I know then. It did not stop there. The company used the cash to repay some debt, refinance its balance sheet and releverage it through acquisitions, triggering a step change in its earnings growth profile and changing the perception of the market. Its labs continued to return the same profit, but change in financial leverage (from 2x to 3-4x) and change in perception  (multiple expansion) led the stock to go up another 5-fold between 2012 and 2017 explained by E = change in fundamental (compounding of earnings worth perhaps 2x over the five year and leverage perhaps adding 1.5x) x change in risk perception (a 1.5x multiplier?).

Wirecard is another European superstock that I had the privilege to buy at EUR 7.5 around the same time. The stock was also trading around 7-8x EBITDA then. I had never heard of Wirecard, until Visa bought Cybersource for 25x EBITDA. I was looking for a way to play the e-commerce boom and was looking for a bucket capable of acting as a major recipient of that money gush. A study of Ebay had raised my attention to Paypal and the electronic payment theme. Visa was now a public company and their acquisition of a pure online payment processing actor like Cybersource was the catalyst for change I was looking for. A simple search of comparable stocks propped up three names: Paypal (part of Ebay), Datacash (too small, but subsequently bought by Mastercard) and a little known German stock called Wirecard. At the time, Wirecard was embroiled in a scandal. A hedge fund had been shorting the stock and spreading rumours that the company had helped an online poker site to sell its services in the United States, which would have been illegal. Scandals are great perception catalysts on the basis that what does not kill you makes you stronger. I called the company and soon realized that little known Wirecard was processing more than 10% of all ecommerce sales in Europe, growing at strong double digit and of course not involved in the practices that were putting its stock under pressure. A take out candidate, the Visa deal gave a blue sky scenario of 25x EBITDA or four bagger. The simple end of the scandal would trigger a perception change susceptible to lift the stock back to 10-12x EBITDA. Meanwhile the 15-20% EBITDA growth underpinned by ecommerce growth in Europe would allow a doubling of the stock every 3.5 to 5 years organically. Fast forward and a few complementary acquisitions later (fundamental change), the stock is now priced at c. EUR 140.

Of course, these super stocks are the exceptions rather than rule, while it is worth reminding our readers that the past performance is no guarantee of similar returns in the future for indeed these two examples should provide a compelling illustration of the compounding effects of value x fundamental changes (real economic value/earnings change) and perception changes. So before you buy a stock, check out how much you would be ready to pay today if nothing changed in the future (value), how much of more value could be created or wiped on top in the future and how the perception (risk or greed factors could change).

The same approach can be applied to any investment cases be it on the long or the short side.

In the same year, BP Plc stock price, an oil major, whose stock price could be considered as one of the most efficient in the world and computed as a direct function of the oil price, was hit by an accident at its Deepwater Horizon accident. Change was at work. What started as fire on an offshore rig (whose costs even high could be seen as temporary and small in the context of BP) turned out into a major environmental disaster off the coast of Louisiana. When the small leak became uncontrollable with millions of gallons released into the sea for an undetermined period of time, the liability costs not only started to rise (fundamental change), but perception also. BP was one of the world’s strongest credit at the time. Its risk of default was close to 0% before the accident. But as the liability grew and the bill was getting out of control as the company was unable to contain the leak and fill the oil spilling hole it had pierced at the bottom of the ocean, the unconceivable happened, a probability of default was starting to be applied too. The stock halved during that sad saga, less than half of that was due to the cost (fundamental change) and the other half by risk perception (perception change). As soon as the hole was filled and leak stopped, the perception changed again. The scandal was over. Perception remained tainted for a while and it took many years for BP to restore credibility, but the stock recovered. Only the final bill stayed.

This E= MC^2 formula illustrate why a pure value investing approach can make money by taking advantage of price anomalies, but could miss the additional multiplier effects of future fundamental changes such as growth etc. A pure price momentum strategy would also probably be able to capture the change in perception, but it would also be at the mercy of pending changes in value and fundamentals. To fully profit from the magic of compounding (the eighth wonder and most powerful in the universe according to Einstein) a complete investor would need to master it all and look at it not as a static formula but within the context of a dynamic system.

He or she would not only need to know how to quantify the value of an asset, understand all the potential catalysts for fundamental changes of that value (be it macro economic or bottom up catalysts) but also appreciate the importance of human behavioral factors and technical ones (perception catalysts).

We should cover some of these catalysts in our next post. Stay tuned.