The Alchemy of Finance by George Soros

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1 The Alchemy of Finance by George Soros Four hundred seventy-three million to one. Those were the odds against any fund manager generating an average annual return of 31% for more than 30 years, yet it's a feat that George Soros was able to accomplish as the legendary manager of the Quantum Fund. Dubbed by BusinessWeek as "The Man Who Moves Markets," Soros is unquestionably one of today's most powerful and profitable investors. Soros is best known as the man who broke the Bank of England. His short-selling of the British Pound in 1992 precipitated the collapse of the European monetary system, and earned him over a billion dollars. It's rumored that he did it again in the Asian currency crises of 1996 and Soros' investment life hasn't always been all success and glory; he has also had some rather spectacular failures. When the NASDAQ hit panic lows of about 1100 Soros found those technology stocks too hot to handle, and dumped them the NASDAQ subsequently bounced up over Despite the fact that his track record isn't perfect, Soros is still one of the giants of investing and he has some great insights to share. As a trader coming of age in the latter half of the frenetic 1970s and 80s, Soros was somewhat of a "contrarian." He rejected the prevailing paradigm in financial economics and created his own theory, which he dubbed "The Theory of Reflexivity." Soros' investment philosophy is based on this theory, which is a practical and powerful model for understanding the underlying dynamics of booms and busts. He credits the theory with giving him the edge he needed to create those tremendous results. Soros admits that his approach isn't really scientific since it doesn't obey strict principles and can't be reduced to mathematical formulae so he describes it as alchemy, not science. Interestingly, it is his alchemy that has resulted in investing success where scientific theories (such as the efficient market hypothesis, the rational expectations theory, etc.) and tools (such as technical analysis) have failed to produce the same stellar results. The Theory of Reflexivity The prevailing paradigm in financial economics holds that market prices are passive reflections of a company's underlying fundamentals (such as earnings, dividends, asset value and cash flow) and that market prices fully reflect all existing known information in other words, investors' understanding of the market as a whole is rational and complete. Furthermore, stocks are presumed to have a true or fundamental value and a stock's price tends toward this true value, which is called the equilibrium price. 1 The Business Source All Rights Reserved

2 Soros' Theory of Reflexivity totally disagrees with the prevailing paradigm. It contends that 1) market prices are NOT passive reflections of a stock's underlying fundamentals, 2) investors' understanding of a stock is neither complete nor rational and 3) markets do not tend towards an equilibrium price, they tend towards boom/bust sequences. The theory also states that the relationship between investor biases (a positive bias is where investors as a whole are bullish and vice versa) and the price of a stock is also reflexive. If the general bias is bullish then people will tend to buy a stock, which leads to higher prices and greater bullishness (a more positive bias). And the greater bullishness will cause more people to buy, causing prices to go up. Soros summarizes his Theory of Reflexivity this way: "...financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect." The Theory of Reflexivity states that there is an interplay between the underlying fundamentals of a stock, investor biases toward the stock and the stock's price. While Soros agrees that fundamentals impact the price of a stock, he believes something that the prevailing paradigm in financial economics rejects; Soros contends that the price of a stock also impacts the stock's fundamentals. The relationship is reflexive, they each impact the other. The idea that there is an interplay between these three factors is unique to the Theory of Reflexivity and it is this key insight that gives Soros his tremendous edge. The Underlying Fundamentals Anyone familiar with financial markets knows that it is expectations that move prices. In this respect, Soros' concept is not unique. However, Soros takes the concept one step further by recognizing that participants' behavior can also influence the so-called "underlying fundamentals" that market prices are supposed to reflect. Stock prices can directly influence underlying fundamental values of a company in many ways. A rising stock price makes it easier for a company to sell more stock and the additional capital raised could be used to finance projects that can make the company more competitive and raise its underlying value. Also, the price of a stock can have an influence on mergers and acquisitions, and company standing (e.g. credit ratings, consumer acceptance, management credibility, etc). The influence of these factors on stock prices is, of course, fully recognized; it is the reflexive influence of stock prices on these factors that is strangely ignored. The boom and bust in Internet stocks provides an interesting illustration of this point. New companies without earnings are critically dependent on their ability to 2 The Business Source All Rights Reserved

3 raise money in financial markets. When the price of their stock is rising, financing is a given and an important risk is eliminated. The fact that the price itself is rising makes the company more attractive, which in turn leads to an even higher price, which makes the company even more attractive. The same thing happens in reverse when stock prices decline. The risk of not receiving financing increases, leads to a drop in price, which increases the financing risk, which causes further decline, and so on one element reflexively affecting the other. The Boom/Bust Cycle As stated earlier, Soros believes that markets do not tend towards an equilibrium price; they actually tend towards boom/bust sequences. The interplay between the underlying trend, stock prices and the prevailing bias is not constant, and because of this, there is no tendency toward equilibrium. In a typical sequence of events, these three variables reinforce each other, first in one direction and then in the other, in a pattern that is known, in its simplest form, as boom and bust. The crucial features of a typical boom/bust sequence are as follows. First, a trend begins (perhaps due to changing fundamentals) but it is not yet recognized as a trend. As it continues, the trend gets noticed by a few market participants and as time goes on the trend becomes recognized by more investors and a positive bias (the expectation that prices will continue to increase) is created. This means people expect prices to go higher so they buy the stock, which creates more demand causing prices to move up, which reflexively reinforces the underlying trend and even more people buy. Beyond a certain point, this self-validating feedback loop becomes unsustainable and a climax is reached. This is where investors begin to see the flaw in their thinking and their bias shifts from being bullish to bearish and a new trend becomes self-reinforcing in the opposite direction. The Soros Edge Reflexivity offers a partial but critical explanation of how stock market prices are determined. First of all, there is an underlying trend in a stock that reflects a stock's fundamentals, such as earnings and dividends. Fundamental yardsticks are relevant but the weight given to each is dependent on each individual investor's judgment and is therefore subject to their bias. Ignoring bias and treating it as mere "noise" is what the theory of perfect competition and the fundamentalist approach to securities analysis have always done. But bias is important because it helps reinforce a trend and is instrumental in creating boom/ bust cycles. Also, Soros believes that there is bound to be a flaw in the investor's perception of the fundamentals and when that flaw is recognized it sets the stage for a reversal in the prevailing bias. The new perception of the fundamentals leads to a reversal of trend, which turns prices lower and a negative bias sets in. 3 The Business Source All Rights Reserved

4 As mentioned earlier, the reflexive sequence of a boom/bust starts with an unrecognized trend, which gets noticed and begins a self reinforcing process, resulting in a growing bias, leading to a widening divergence between reality and expectations, the flaw in perceptions is discovered, the climax is hit and the self reinforcing process starts driving prices in the opposite direction. "The reflexive model cannot take the place of fundamental analysis all it can do is provide an ingredient missing from it. Fundamental analysis seeks to establish how underlying values are reflected in stock prices while the Theory of Reflexivity shows how stock prices can influence underlying values. One provides a static picture while the other provides a dynamic one." The Theory of Reflexivity offers a more complete explanation of stock price movement and as long as one investor understands something that other investors do not, he has an edge. Reflexivity has delivered that edge to Soros and created huge profits for him over the years. Applying The Theory of Reflexivity through Real World Examples In order to better understand how the Theory of Reflexivity works, Soros provides some real world examples that detail how he successfully used his theory. a. Positive Bias and The Mortgage Trust Boom/Bust In February 1970, Soros published a research report entitled "The Case for Mortgage Trusts". In it, he explained the underlying trend [equity leveraging by real estate mortgage trusts (REITs)] and predicted the sequence of events and eventual outcome: Act 1: At present, the effective yield on construction loans is at an optimum and losses are at a relatively low level. There is pent-up demand for housing and new houses readily find buyers. There is a shortage of funds so that new projects that do get off the ground are economically well justified. Investor recognition of the REITs concept has progressed far enough to permit the formation of new trusts and the expansion of existing ones. The self-reinforcing process gets under way. Act 2: With a growing market and growing investor recognition, the premium over book value of REITs may continue to increase and is likely to show a rapid rise in per-share earnings. REITs are likely to take full advantage of the premium by issuing more trust units and, since the entry into the field is unrestricted, the number of REITs will also continue to increase rapidly. As a result, more money becomes available for REITs to invest. Act 3: The self-reinforcing process will continue until REITs have captured a significant part of the construction loan market. Construction activity itself will become more speculative and bad loans will increase. Eventually, the housing boom will slacken off and housing surpluses will appear in various parts of the country, accompanied by a slack real estate market and temporary declines in real estate prices. As this point, some of the REITs 4 The Business Source All Rights Reserved

5 will be bound to have a large number of delinquent loans in their portfolios causing banks to panic and demand their lines of credit be paid off. Act 4: Investor disappointment will affect the valuation of the group, and a lower premium coupled with slower growth will in turn reduce the pershare earnings progression. The multiple will decline and the group will go through a shakeout period. After the shakeout, the REIT industry will have attained maturity: there will be few new entries, regulations may be introduced and existing trusts will settle down to a more moderate growth rate. Subsequent events took the course outlined in Soros' report. Shortly after the report was published, Soros invested heavily in REITs and took some profits near the beginning during Act 1. He did get caught in the downdraft with a significant inventory but held on and even increased his positions. He followed the industry closely during Act 2 and sold his holdings at that time with good profits. Then he lost touch with the group until a few years later during Act 3 when the problems he predicted started to surface. He sold the group short more or less indiscriminately and as share prices fell Soros added to his short position. His original prediction was fulfilled and most REITs went broke leaving Soros with huge profits on his short positions. Because of Soros' ability to understand the reflexive nature of the boom/bust cycle, investor bias, and the underlying fundamentals, he had a much clearer picture than the average investor of when to buy and sell REITs and was able to generate huge profits. b. Negative Bias and the Technology Boom/Bust According to Soros, perhaps the most interesting case of negative bias occurred in technology stocks. After the stock market debacle of 1974, investors were leery of any company that needed to raise equity capital from outside sources. Distributed data processing was in the early stages of development and new companies such as Datapoint and Four-Phase were unable to raise capital as the stocks were selling at very low multiples of anticipated earnings. The main argument against them was that they would not be able to grow fast enough to meet demand and eventually IBM would move into the market. Investors had a decidedly negative bias in this area. Because of the prevailing negative bias, few bought into these companies and a great investment opportunity was missed. The interpretation of the fundamentals proved to be incorrect and these companies actually became very large and prosperous. This bias wasn't just noise as the fundamentalists would tell us it was real and it kept investors out of a very profitable sector. After these stocks made large moves it became evident that the popular interpretation of the fundamentals was wrong, the bias changed and investors 5 The Business Source All Rights Reserved

6 became eager to throw money at them. Those who had been willing to fight the negative bias early on were amply rewarded and those who didn't missed most of the move. The negative bias of the period gave way to the opposite extreme. It eventually found expression in the most recent venture capital and technology boom. The sequence of events is not as clear-cut as in the case of REITs, but that is because technology is not as homogenous an industry. However, the same reflexive interaction between stock prices, prevailing bias, and fundamentals occurred creating a phenomenal market opportunity. Successful Speculation Soros' competitive advantage lies in recognizing changes in the rules of the game (new trends and prevailing biases) and finding mistakes in them i.e. recognizing the fundamental flaws. Soros often makes a conscious decision to find investments that are at odds with the prevailing opinion because that is where the best profit opportunities are found. He defines his task as engaging in arbitrage between his own judgment and the prevailing view. Soros tells us that stock prices are determined by the reflexive interaction between stock prices, prevailing biases, and fundamentals, not just the fundamentals as the existing economic paradigm would have us believe. Also, Soros tells us that investors often incorrectly interpret fundamentals and these misinterpretations can provide excellent investment opportunities for those with a keen eye as in the case of the British Pound, REITs or technology stocks. George Soros is undoubtedly one of the most successful investors of all time and his Theory of Reflexivity has proven to be a profound and powerful model for identifying market dynamics. With Soros' help we certainly have a better understanding of booms and busts together with critical insights for improving our overall investment success. 6 The Business Source All Rights Reserved