Friendly Neighbourhood Investment Banker Not A Stock Picker
Seems counterintuitive right? People who literally look at stocks all day and tell corporates how to take on corporate actions (such as mergers & acquisitions, dividend hikes and share repurchases, and play Nostradamus on how the market will respond to things in glossy presentations) are usually bad investors.
As we discussed in a prior post, a large percentage of investment bankers either do not invest or invest foolishly, with many of them losing money. If they never invested a dime, they would be far wealthier than having done so. Also, investment bankers tend to experience lifestyle inflation and are constantly running on a money treadmill (generally the ones that were not born wealthy) and may have a negative net worth compared to you, but we will save that for another day.
So why are investment bankers bad investors?
90% of People Are Bad Investors
The main reason is because people in general are bad investors. When it comes to money, everyone falls into a different psychological state and succumb to behavioral finance pitfalls that have been studied in psychology for decades. People who would otherwise be very rational, such as doctors and lawyers, have lost billions of dollars trying to time the market, betting on a “hot stock” or latest trend such as Bitcoin or cannabis, or selling out at the bottom out of fear/buying at the top because of the fabled “Fear of Missing Out”.
People are inherently greedy and fall for get rich quick themes. The same reason why people join multi-level marketing or pyramid schemes or buy something from an infomercial, people want instant gratification and are unable to see that they are being fleeced by someone who is selling a product and playing to natural desires.
Investment bankers are people too – just people with compromised immune systems.
The market returns 8-10% a year on average, and this figure is not enough to move the needle for people. Compounded over time, this is immense and life changing, but over the course of a year the figure is not attractive. Accordingly, people demand 20% returns or 30% returns with “no risk”, which is a paradigm that does not exist. This is simply impossible – especially for people who spend no time looking at valuation from an objective perspective and evaluate all of the risks and mitigants via conducting thorough scenario analysis with the understanding that they could be wrong.
There certainly are people who are capable, but this is not someone who is holed up in a bank for 18 hours a day, 7 days a week making PowerPoint decks. The people who can do this charge a lot of money for their services and require large account minimums to participate in their hedge funds.
Investment Bankers Believe Their Own Hype
Tell a lie enough times and it becomes the truth.
Investment bankers are marketers, not investors. They are paid for working on transactions similar to any other commission job – but most similar to a commercial real estate agent or broker.
If their fees and bonuses are based on 1) a transaction and 2) the size of the transaction, investment bankers are inclined to market the stock to the best of their ability. This may involve Equity Capital Markets, or something as basic as crafting an investor presentation for road shows that bankers are responsible for.
For excellent companies such as Alphabet or Amazon, the companies do sell themselves to some extent (and they certainly do not need investment bankers for many things). However, a lot of the coverage universe for the investment banker has to be the bottom quartile or bottom half of investable companies. They are not going to market their lack of earnings or poor capital allocation strategy, so they will market other things such as hypothetical growth or a strong underlying asset.
This is standard commercial pressure and fair game. Sometimes a whole industry screens poorly (such as natural resources) and bleeds cash flow year over year. Investment bankers always like to say that EBITDA is an important figure for valuation multiples and tout operating cash flow.
This deviates from sound value investing and is the target of Warren Buffett’s scathing commentary year over year.
Does it make sense to invest in a company that has never made a profit in its existence? If a company’s EBITDA is high but it has onerous interest payments and after capital expenditures to sustain the business it is heavily cash flow negative with no catalyst in sight to make it positive, is this a logical place to park your money?
The answer is no, and EV/EBITDA multiples cannot be looked at in a vacuum before determining that a stock is “cheap”. Multiples are not a substitute for a profitable business. For a layman, he would never invest in a company that does not make money. When people are in stocks, this regresses into lunacy and mania.
People invest in what they know. This is evidenced by Texans having a heavier portfolio weight in oil and gas, Chicagoland residents having a higher portfolio weight in industrials, New Yorkers having a heavier portfolio weight in financials and Californians being heavy in tech (and accordingly people from California have had the highest portfolio returns).
If investment bankers have a poor coverage universe, they can fall into the trap of believing what they peddle every day and start plowing their own money in there. Investment bankers that covered Micron Technology did well for a few years (probably not now) but bankers that covered Peabody Energy may not have (coal is dead in America and Trump cannot bring it back).
It also puts more astute investors into a narrow lens. For instance, they may be in frequent contact with companies and lobbyists who have a certain view of the world and it would be absurd for regulators and governments to do anything that is not in accordance with this view. This never works out – investing is a game of probabilities not hope.