Life and Death in the Equity Market

Deep value investors at work.
In my humble estimation most investors have a limited view of the market ecosystem. This is the fault of the financial advice industry (which emphasizes performance comparisons to sell products and services) and also the financial media (which emphasizes performance comparisons even more than the financial advice industry).

When you look at markets from that point of view, there are “winners” and “losers.” The “winners” are always doing so at someone else’s expense. Usually mom ‘n pop. Or mom ‘n pop’s ineptly managed pension plan.

Make no mistake. Markets are competitive. But they are also vibrant and nuanced. As with any ecosystem, most of the “organisms” in the market contribute to its health in some way.

David Merkel tackles the market ecosystem in two excellent pieces:

Broadly speaking, he writes about the differences between “balance sheet players” such as banks and insurance companies and “total return players” such as hedge funds and mutual funds. These entities have different investment objectives and constraints and so behave very differently in the markets.

I want to go through a similar exercise. Of course, what is written below involves simplification and generalization. I also focus specifically on equity markets for simplicity. The real world is more complex. But I hope this helps readers think about markets in a more nuanced way.

Traders vs. Investors

At a very high level you can separate the market ecosystem into traders and investors. Traders have short time horizons (sometimes as brief as a few seconds, in the case of high frequency, algorithmic trading). Investors have long time horizons (sometimes as long as decades, in the case of Warren Buffett). Perhaps more importantly, traders and investors make different contributions to the health of the market ecosystem.

Traders’ Contributions To The Market Ecosystem

Traders buy and sell based on anticipated changes in the supply and demand for securities. They contribute to the health of the investment ecosystem by making markets and keeping bid/offer spreads narrow, which reduces the cost of trading for other market participants.

Arbitrageurs are a subset of traders that enforce price relationships among various financial instruments. For example, arbitrageurs ensure that ETF share prices track closely to their net asset values. You can read more about this process at

Many traders are completely unconcerned with the direction of markets. Rather, they attempt to capture small pricing inefficiencies at relatively high frequencies. 

Some traders simply execute transactions for longer term investors and attempt to do so as efficiently as possible. For a large investor that is far from a trivial task. It is one thing to buy $10,000 worth of KO shares and quite another to buy $10,000,000 worth of shares. The latter will move the market.

Investors’ Contributions To The Market Ecosystem

Investors buy and sell securities based on market prices relative to their estimates of “intrinsic value.” Investors contribute to the health of the market ecosystem by ensuring security prices properly reflect underlying economic value. Broadly speaking, there are two subspecies of investors in equity markets: value investors and growth investors.

Some people mistakenly believe value investors seek to buy assets at a discount to intrinsic value while growth investors buy at a premium. This is not true.

Value investors typically demand a much greater “margin of safety” (extra discount from intrinsic value) to buy a security. They tend to gravitate toward businesses that generate profit and excess cash flow, but have modest growth potential. An example of a value stock would be Exxon Mobil or another large integrated oil company. Growth rates are less important to value investors than cash flow and profitability. Value investors tend to focus on what could go wrong in the future versus the potential reward if things go well.

Growth investors gravitate toward businesses where future profits and cash flows are potentially much greater than they are today. These are stocks such as Facebook, Amazon, Netflix and Tesla. Some growth stocks are profitable today (Facebook). Others are kind of profitable (Amazon). Others generate large losses (Netflix, Tesla). The level of profitability today is of less concern to a growth investor than the potential profitability in the future. Growth rates and addressable market size, on the other hand, are of paramount importance to growth investors. Growth investors would prefer to own businesses that will change the world and accept the risk and uncertainty that goes along with that stance.

Popular misconceptions regarding value and growth investors stem from the fact that growth investors tend to own stocks that trade at relatively higher valuations, as measured by ratios such as price to earnings. Regardless, growth investors are always buying at a discount to their estimate of a stock’s intrinsic value.

Life And Death In The Equity Market

When a stock is born (or, rather, goes public), it may start as a high-flying growth company. The business may not be profitable, but as long as it is growing revenue and can capture an increasing share of a large addressable market then growth investors will own the stock. These investors ensure the stock’s price properly reflects the growth potential of the business. The main risk for a growth investor is that a company’s growth rate slows much faster than anticipated.

As a business matures, its growth rate declines and its market share stabilizes. Ownership will transition to value investors who will want to see profitability, cash flow generation and the return of cash to shareholders through dividends and share buybacks. The main risk for a value investor is that growth rates and markets never stabilize, but instead continue to spiral downward. This is called a “value trap” and it is a value investor’s worst nightmare. Another, less prominent risk is that the management will do stupid things like divert free cash flow or take on debt to do silly acquisitions to “buy” growth. A major reason value investors want to see free cash returned to shareholders is to prevent management from doing stupid things with it.

Most businesses will eventually enter terminal decline. There are many reasons for this but the outward signs include falling profitability, sharply declining market share and increasing amounts of debt. Eventually, if a company does not make significant changes, it will become insolvent. When a company reaches this final stage of its life cycle the “deep value” or “distressed” investor steps in to own the stock. The distressed investor evaluates the various securities in the capital structure to identify their value in a restructuring or liquidation. Thus the distressed investor seeks to buy at a discount to liquidation value. The main risk for a distressed investor is an adverse event or legal decision involving the business that unexpectedly changes the liquidation value of the securities in the capital structure.

When a company finally liquidates, its capital may ultimately end up recycled into young companies in the public and private markets.

And so the cycle can begin again.

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