Talking Your Book: Social Networks and Price Discovery
- Wesley R. Gray and Andrew E. Kern
- A version of the paper can be found here.
- A related paper can be found here.
We study how professional investors use social networks to impound price-relevant information into asset prices. Exploiting novel data from an online social network that facilitates information sharing among fund managers, we find that long (short) recommendations released into the private network generate cumulative abnormal returns of 3.61% (-4.90%) over a twenty-day window. These results suggest that social networks play a direct role in facilitating the price discovery process.
Data for this paper come from the recommendations posted to Valueinvestorsclub.com from January 1, 2000 through December 31, 2008. Stock prices and fundamental data are collected from CRSP/Compustat.
I’m not sure if we will ever really know if markets are efficient or if they are inefficient, however, I do know this: making money is NOT easy and it takes a lot of time, skill, and luck.
One group of investors that epitomize the intellect and skill it takes to succeed as a professional investor are the members of ValueInvestorsClub.com (VIC)…or at least that is how the story goes. VIC membership consists almost exclusively of smaller fundamentals-based hedge fund managers who focus on “stock-picking” as a way of life. The site facilitates the exchange of actionable trading ideas in real-time and encourages discussion and debate on the thesis presented. If you are a value investor that has been living under a rock for the past 10 years, I suggest you head over to their site and check it out.
Below is a table from the paper, which highlights how VIC members choose their stocks (to create this we read every single thesis ever posted on VIC and gave each recommendation a discrete criteria based on the nature of the write up).
The point of this paper is two-fold:
- Understand why a money manager may share good information with the competition (Talking your book).
- See how the market reacts to investors who presumably “talk their book.”
Why share good ideas?
The classic market efficiency argument goes as follows: smart people are continuously monitoring market prices, and if a mispricing occurs, the smart people immediately buy as much of the undervalued asset as they can, thus driving prices back to fundamental value. Along this path there is no logical reason why a profit maximizing investor would ever want to SHARE his information with another investor–why not keep all the “alpha”? Of course, the efficient market arguments forget a few things like transaction costs, short sell constraints, leverage constraints, behavioral biases, institutional frictions, agency problems, and so on and so on…
If you want a deep understanding of the issues surrounding this question I suggest you check this paper out. For the rest of us, who operate by KISS, understanding the primary driver behind idea sharing is fairly straight forward: investors share ideas to “talk their book.” For example, if I already have all my money in a stock or I’ve hit a risk limit in my portfolio (e.g, 10% of NAV), there is no cost to sharing my private information. Perhaps I’ll get lucky and convince another value investor that the stock is cheap and the price will rise. Or maybe the market crashes 50%, but because I’ve made others aware of my cheap stock, the stock only drops 30% as value investors come in and provide support.
Talking your book is a simple idea, and there are many anecdotes of professional investors engaging in the activity. If you have ever attended a Value Investing Congress session, you have undergone flagellation by numerous “talk your book” investors. Or maybe you’ve plowed through one of Bill Ackman’s 100pg+ power-points on his recent activist plan (let’s just hope nobody took the sucker bet on Target.) Perhaps you saw David Einhorn’s amazing research on The St. Joes Company? These are all examples of “talking your book.” Unfortunately, piecing together these numerous anecdotal examples is difficult, and assessing how “talking your book” affects stock prices is not very scientific–until now…
VIC, at some level, is explicitly designed to facilitate talking your book. And because the organization has a relatively long track record of recommendations, creating a large scale sample to assess how talking your book affects stock prices is finally possible.
So how does the market react to VIC recommendations?
The case study of IASG exemplifies the findings from the paper. Prior to the December 7th, 2006 recommendation, IASG tanked relative to the market. After being recommended on VIC the stock jumped by almost 10%! In the next few weeks the stock slowly drifted upwards (on a risk-adjusted basis) until it was announced on December 21, 2006 that IASG would merge with Protection One.
The results from the IASG example are representative of the entire sample of VIC recommendations. In the graph below, the dotted line represents the return path of short recommendations and the solid line represents long recommendations.
A few points of interest:
- Short ideas outperform prior to posting, and long ideas underperform prior to posting–presumably, the short ideas are becoming ‘overvalued’ and the long ideas are ‘undervalued.’
- After posting, short ideas tumble and long ideas see a large upward spike. In both the long and short scenario there is a continual ‘drift’ following recommendation.
- The ideas posted are actually valuable to whomever purchased them prior to recommendation AND after recommendation!
- Find honest to goodness undervaluation or overvaluation. (Obviously, if you aren’t discovering genuinely “good” ideas, talking your book is not going to work.)
- Take a full position in the stock.
- Crank on your PR engines and spread the word about your idea (VIC, Sumzero.com, SeekingAlpha, etc.). Here is a paper looking at the performance of Seeking Alpha posts.
- Drive prices closer to fundamentals in a shorter amount of time.
Talking your book is an interesting concept and closely parallels the “pumping your book” concept, which is more nefarious. Understanding the difference between “talking” and “pumping” is a critical insight one must understand before they engage in either activity. Talking your book is the actual sharing of good ideas, whereas pumping your book, is sharing rumors/lies/misinformation regarding a stock that is already fully valued and/or overvalued (this strategy takes advantage of the “sucker born every minute” concept).
Pumping your book is unethical and against various regulations, however, there are many ways investors should think about leveraging the benefits of talking their books. Often, investors simply focus on investing, but sometimes they forget that the stock market is part investing and part beauty contest. Those investors who simply rely on the broader market to magically find their undervalued stocks, may end up sitting on an undervalued stock for many years before the valuation reaches a “fair” price. Why not share your scoop with other value investors? Sharing is a win-win for everyone: Other investors access new ideas, and prices reflect fundamentals sooner rather than later.
Note: While we discuss “talking your book,” I am engaged in talking my own book of research–kinda ironic…