For fundamentalists, the value of an asset is the sum of the returns it will yield over its life. For fellow travellers, an asset is worth what someone else is willing to pay for it.
Last week, the Shanghai stock market reached new highs, London house prices shrugged off higher interest rates and a new hedge fund invited punters to take positions in the art market. Out in Nebraska, Warren Buffett, the world’s most successful investor, delivered his annual homily to the admiring stockholders of Berkshire Hathaway.
There are two approaches to valuing assets. For fundamentalists, the value of an asset is the sum of the returns it will yield over its life. For fellow travellers, an asset is worth what someone else is willing to pay for it. The conflict between fundamentalists and fellow travellers is the root of many financial controversies, over investment styles, over fair value accounting. Anyone who owns, or might buy, a Chinese share, a house, or a work of art is pressed into – implicitly – taking a view.
As with other doctrinal disputes, the debate between fundamentalists and fellow travellers would resolve itself in a perfect world where the future was known with certainty and everyone had the same preferences.
A world dominated by fundamentalists is a lonely place, its inhabitants scattered in locations such as Omaha. Buyers and sellers constantly make independent assessments of value, coming up with answers that vary over time, across individuals and with collective states of mind. The price is an average of their assessments, it follows a trend but it is impossible ever to be sure whether a rise or fall represents a deviation, subject to mean reversion, or a shift in the trend itself. Fundamentalist life can be nerve-racking, but fundamentalists can reduce the cost of risk-bearing by simply not following day-by-day price fluctuations too closely.
Fellow travellers, however, cannot afford to be away from their screens, or the streets of London or Manhattan, for even a short time. Fellow travelling is a social activity and successful fellow travellers are constantly second-guessing each other, estimating not just what each other will pay but what they might be willing to pay tomorrow, what they think others will think and what they think others will think they think.
Fellow travellers create bubbles, when markets become dominated by the belief that you can sell on anything you buy at a higher price to someone else. Once every potential fellow traveller is on the road – there are no suckers left – these bubbles burst.
Fundamentalists such as Mr Buffett can sometimes infiltrate the society of fellow travellers. They can reconcile the fundamentalist and fellow travelling doctrines by observing that, for the patient investor, the value of an asset is always the higher of market value and fundamental value – you have the choice of selling it now or holding it for life. Professional fund managers, however, are generally confined to the company of other fellow travellers. They are forced to mark to market every day and are benchmarked to relative performance.
The Chinese stock market is frequented mostly by fellow travellers, but the housing market is populated by fundamentalists. Most people who buy houses, even in the last stages of housing booms, are buying them to live in. Their decision is based on their assessment that the returns to them over the years will exceed the price. Their judgments may be panicked or mistaken but are based on fundamental value. There are a few pockets of exception to the principle that people buy houses to live in – where buy-to-let predominates or off-plan purchases in speculative developments – but these exceptions prove the general rule. Nemesis in Shanghai is certain. Nemesis in the housing market is not.
And what of art? The market for the most expensive art has two distinctive features. In the long run the supply of houses responds to the price and the supply of Chinese equities is potentially very elastic indeed, but the supply of old masters is fixed. And because the supply is so limited, only a few fellow travellers need to be recruited in each decade. There are few assets whose prices can remain for ever unrelated to an assessment of fundamental value. So Mr Buffett owns his Omaha bungalow, and even a stake in PetroChina but no old master collection.