Incentives matter

I suspect that a lot of my readers also visit the Whopper Investments blog, so you might have noticed that I gave this post an identical title as his last one: Incentives matter. Whopper summarizes my thinking about the subject in the following sentence: “I believe that people are always going to do what’s in their best interest”.

This is of course very important when you scrutinize what insiders are doing at a company, but it is equally true when you read an article online. What are the incentives of the author? I recently wrote a post for Seeking Alpha about Deswell Industries. For regular readers of my blog not a new name since I own it since the beginning of 2012. At the time I spend little time about looking at the underlying business, my main concern was whether or not the company was potentially a fraud since it’s doing business in China.

So my incentives for writing this post, and publishing it on SA:

  1. Reviewing and updating my investment thesis
  2. Gain some exposure on SA, maybe attract some new readers to my blog
  3. Last but not least: make a few bucks

SA pays authors a minimum of $150 dollar for a good article on a under-followed micro/small cap while there is minimum payment of $500 dollar for an article that is selected as an “Alpha Rich” idea. So what is your incentive as a writer: to write a piece that convinces the SA editors that the stock offers an asymmetrical risk/reward ratio! It’s no longer about publishing the most balanced research. Of course you should mention some negatives because you sound smarter if you do, but it’s easy to downplay a specific issue. I wish it wouldn’t be true, but after writing the article I realized how you are tempted to do it. Even without the money the incentive would be there: it’s also an ego thing.

In the case of Deswell Industries I don’t think it would have been too hard to write an article that sounded a lot better. You have the downside part of the story covered with the large amount of cash on the balance sheet, and it’s easy to write for example a nice story on how the business has decent long-term prospects (not impossible) or how the leasehold land of the company could potentially be a very valuable asset (for the record: I don’t think this is very likely, but you see on SA a reader that is trying to make this case). It doesn’t even matter if you fool the SA editors or not, the end result is the same.

So what does this mean for me?

My number one motivation of starting this blog is to improve my investment process and skills. I often think about my write-ups as a sort of public visible checklist (without the checks). By writing an ‘exclusive’ article for SA I’m giving myself a competing incentive, and that is a dangerous thing because it’s already easy enough to be biased towards your own idea’s. So you don’t have to expect a lot of other SA articles from me in the future, although I might occasionally review an existing position (or maybe write about something I don’t own).

A slightly related topic is my decision to keep the blog free from advertisements. That would also introduce a competing incentive: away from the quality of posts and towards the quantity of posts. I don’t think advertising revenue would be material anyway, so no reason to do something that subtracts from the main goal of the blog.

What should it mean for you?

Nothing! You should be doing your own thinking and research anyway. But when you read something it still pays to think about the incentives of the writer, because it can tell you where you could start looking to find the weak points in the thesis. Unfortunately this means on SA that authors have an incentive to make the story sound as positive and convincing as possible. I understand why they are doing this, because it’s at the same time also an incentive for people to write true “Alpha Rich” articles, and I think they are succeeding with that part of the equation. I do see more interesting articles appearing than in the past.

11 thoughts on “Incentives matter

  1. krullebol

    “I believe that people are always going to do what’s in their best interest” is a statement that sounds an awfully lot stronger than “incentives matter”. The first statement feels like a statement that is too strong.

    E.g. Why do people smoke? You could argue that the pleasure derived right now outweighs the long term negative health benefits given some personal discount rate of the future benefits. But that sounds a bit lame. Why do I binge on Haribo on occasion? Frankly, I always feel terrible within 15 minutes and even though I hate this and I know this, I still find it difficult to act according to the incentive. Of course quite often I can use this knowledge to avoid the binging, but it doesn’t always work. Maybe a lack of sugar impairs my ability to act according to the incentive?

    The always version of incentives sounds like the strong form efficient market hypothesis: it helps making your analysis (mathematically) tractable, but you may not necessary explain all aspects of reality.

    To use a quote from one your gurus: I think there is a danger here that you may act as the proverbial guy with the hammer if you truly believe the strong version and act accordingly.

    Reply
    1. Alpha Vulture Post author

      I agree with you, not everything can be explained by rational behavior even when you look beyond the first level of motivations. Couldn’t find the article anymore, but thought that it was in the economist were they recently had an interesting piece on how drug addicts behave pretty rational when they are given the choice between drugs now or money in the future.

      Reply
  2. NeverLoseMoney

    I think that giving exposure to the stock the author of the article owns is a very important incentive. Much more important than any direct payment from SA itself.

    I watch the price action of some of these stocks after they are profiled on SA or on some blogs and it sometimes amazes me. It’s funny: for some of the obscure, small stocks out there without an obvious catalyst, a blog-post or SA article from a well respected writer has actually become the catalyst. There’s nothing wrong with that, but of course it can be abused.

    It reminds me of a company Buffett invested in in 1999 and 2000, Bell Industries (probably for his personal account?).
    See:
    http://articles.latimes.com/1999/dec/14/business/fi-43809
    http://articles.latimes.com/2000/jan/18/business/fi-55214
    http://articles.latimes.com/2000/nov/09/business/fi-49227
    The price action there even made Buffett look like a pump-and-dumper!

    A writer can’t control the reaction of the readers of the article. It can lead to bizarre consequences though, where a long-term value investor sells very quickly after publication, simply because the share price is going through the roof and his estimate of the intrinsic value is reached. At what point does it become questionable or does it start to look suspicious to others looking at these articles and the reaction of the investing public to these articles?

    Reply
    1. Alpha Vulture Post author

      Interesting articles about Buffett and Bell Industries, new story to me :). And yes, I agree that people pumping their own positions is also an incentive that shouldn’t be underestimated. Especially for very small market cap stocks or short positions this is a concern.

      I do think that in most cases when a stock reacts favorably on a post or SA article that the author doesn’t (directly) profit from it. Are you selling on a 10% pop when you have bought something that you think could be worth +50% or more? I wouldn’t, and if you want to go for the pump-and-dump: you can’t create a convincing story out of thin air. So there are limits to the impact of the pump-and-dump incentive.

      PS. What’s possible the strongest incentive for people to write positive stories is cognitive dissonance: we are all human, and that’s why I want to be careful to introduce incentives that can compound this problem for myself.

      Reply
      1. NeverLoseMoney

        I agree that in most cases the author will just hold the stock he profiled, even if there is some positive market reaction after publication. I think, to a large extent the size of the pop depends on the reputation of the writer. Buffett’s reputation was such that news about him buying Bell Industries created this self fulfilling prophecy. Of course no one on SA can emulate that, but some writers are more respected than others. One possible way this can be abused is by paying someone with a good reputation to profile a certain stock. Like you said though, you can’t just fabricate an investment case out of thin air. For some small, neglected stocks, simply putting them in the spotlight can have a big impact though. Just thinking about incentives and human nature, it would not surprise me if things like that are taking place.

        BTW: I completely understand why you prefer posting on your blog instead of SA and as a reader, I much prefer to read a blog than articles on SA. On a blog there’s also room for random posts and thoughts and there’s no editors telling you what to do.

        Reply

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