For what it's worth...
I am hopeless at haggling. I don’t like shopping at the best of times but it’s many times worse when the price depends on a pointless game of chicken; pointless because, unless my adversary gets a fly in their eye, I’m going to blink first. This was especially evident during our recent trip to India. We arrived at our Delhi hotel shortly after lunch, tired after a long flight (and a sleepless night fretting about visas) but keen to make the most of our stay. We had a quick shower and asked the hotel to arrange a car to show us the city – or, at least, make a start.
Rajinder, our driver was great. A Sikh, tall and handsome, immaculately dressed in a white uniform and black turban – ha! This was the business! Only the tiny white car we three squeezed into shattered the illusion that we were oligarchs. His response to our plea to take us somewhere interesting was the Gurudwara Bangla Sahib, Deli’s largest Sikh temple and where he worshipped. We respectfully padded barefoot through the prayer halls, the peaceful courtyard with its vast pool and the kitchens, smiling and gesticulating to the women volunteers sitting on the floor preparing chapati for the incredible ten thousand meals they give away each day. It was the perfect introduction to India.
On the way back to the hotel Rajinder asked if we’d like to see some pashminas – very fine and no need to buy anything. Suffice to say, when we left the small shop we were over £1,000 poorer and had little to show other than half a dozen pashminas, which may or may not have been finest cashmere, and the promise that a hand knotted Kashmiri tribal silk rug would be sent to us, to arrive when we got home. There, I told you I was hopeless at haggling, but my excuse is that I was very tired!
I’ve no excuse for being rubbish at bargaining. I understand what I should do – I’ve even spent years studying it – but it really hasn’t helped much.
Game theory is the scion of economics that plots possible bargaining strategies and suggests the optimum course to take – the dominant strategy. In a game of chicken, the dominant strategy is to close your eyes, put your foot hard to the floor and drive your metaphorical car directly at your opposite player – but only if they are absolutely convinced of your sincerity. When I was being taught this stuff a few years back, it was by a pretty, petite French lecturer who used the example of the Beer and Quiche game. It’s set in a bar and there are two actors – Toughies and Wimps. Toughies like beer and Wimps like quiche. Toughies also like to beat-up Wimps. The aim of the game is to decide the dominant strategy for a Wimp to get out in one piece. I smiled when the lecturer gave a gallic shrug as she observed in her heavy French accent ‘when I go a bar, I do not like beer but I do not get beaten up…’ What becomes apparent is that the success of your evening, as with so many things in life, will depend on your credibility.
Game theory has been important beyond helping avoid bar room confrontations. The real danger erstwhile defence secretary Michael Fallon presented wasn’t to young women with his unwanted under-table fumbling but to world peace with his threat to sanction first use of our nuclear armoury in the Syrian theatre. The world avoided Armageddon throughout the cold war because of a MAD concept – Mutually Assured Destruction. In this game theory-based approach each player has the ability to annihilate the other and will do so if attacked. In this scenario, the dominate strategy is ‘not to strike first’ but to retaliate if attacked. However, if one player announces he is to follow a sub-optimal strategy (cue Mr Fallon’s sabre-rattling threat) then the dominant strategy shifts to ‘strike first’. What saved us from a nuclear holocaust was that no-one outside Mr Fallon’s party faithful found his threat remotely credible.
Credibility is key in investment markets too. Radi has been commissioned to work on a joint project with a UEA academic, looking at the implications of Neil Woodford’s rapid loss of credibility. For those who haven’t followed the saga, Mr Woodford was for many years a leading active fund manager, following a ‘value’ investment style that was, more often than not, a successful strategy right up to the financial crisis.
In 2015 Mr Woodford launched his eponymous Patient Capital Trust offering ‘exposure to a mix of exciting, disruptive early-stage companies and the scaled, commercial enterprises they become if successful’. This was an important shift from the more conventional approach he had at his previous employers, Invesco. By moving from investing in listed companies, where the market provides a broadly accepted, if flawed, opinion of value, to unlisted private companies where the opinion of value sits with Mr Woodford and those instructed by him, he created an obvious conflict of interest – it will attract more money to his funds if the valuations he ascribes to his unlisted investments are, shall we say, on the rosy side.
This is where credibility becomes vital. Problems at one or two of his holdings sowed the seeds of doubt over valuations which quickly flowered to the current position where his estimates have no credibility; it is pretty much assumed that all his unlisted holdings are significantly and systematically overvalued. The resulting rush to the door meant this became a self-fulfilling prophesy. As a result, early investors in his investment trust are sitting on losses of nearly 60% in a little over four years.
This is not a problem that is solely confined to the Woodford funds. We routinely see start-up businesses with little more than an idea sketched on the back of a beer mat raising funding at valuations that appear to be disconnected with reality. While this seems great for the start-up entrepreneur it causes real problems further down the line. As the business develops, the potential becomes clearer and valuations become more realistic, early investors, loathe to accept they paid too much, stymie further finding rounds.
The tax system and low interest rates have compounded the problem. EIS and SEIS are great in theory for encouraging people to invest in the firms of tomorrow, indeed we recommend them on a regular basis. However, an unintended consequence of the tax incentives is that, as the net cost of failure is subsidised heavily by the Exchequer, due diligence and careful valuation go out of the window in the scramble not to miss out. This is particularly apparent in London and the South East where there is simply too much money chasing too few deals. It’s a similar case with many AIM stocks. The accounting scandal at Patisserie Valerie saw the business sold to its management at around tenth of its ‘value’ just months earlier – which suggests, even taking into account the £30m black hole, that the underlying business was fundamentally overvalued.
Smaller company shares such as Patisserie Valerie, listed on the smaller and less liquid Alternative Investment Market (AIM) are widely used to protect estates from inheritance tax, as they qualify for Business Property Relief. If the tax rules are changed then we could see a rush to the exit and a resultant collapse in value that will make Woodford’s travails seem like a good day at the office.
On a larger scale, cheap money has led to the emergence of firms like WeWork and Uber – hugely unprofitable yet claiming valuations of billions. The recent pulling of the WeWork IPO, even at a price that would have seen Softbank (one of the key investors) slash the value of its stake, could yet prove to be a watershed moment.
I am concerned when something just doesn’t make sense. That feeling that all it is going to take is someone brave enough to shout ‘hey, the Emperor has no clothes’ for the whole facade to come tumbling down. I may be about as good a gambler as I am a haggler, but if I were to put money on the roots of the next financial crisis it would lie in the valuations of unlisted companies and the implications of a loss of credibility spreading like wildfire to engulf wider financial institutions. As with the financial crisis, high risk investments are being bundled into seemingly innocuous collective investments that hide the true nature of the underlying risks the investor is facing. Ten or so years ago it was sub-prime mortgages bundled into Collateralised Debt Obligations; today it’s unlisted and illiquid listed stocks into funds such as the Woodford Equity Income Fund. These are then sold to increasingly naïve investors as relatively low risk and at dubious valuations on little more than the reputation of the manager.
Arriving home, my own reputation was also in tatters. The risk I’d taken in expecting the rug to be delivered was merely the first in what became a long line of poor purchasing decisions – from Ganesh to puppets, our house now resembles a bazaar with things that looked great in Pushkar or Jaipur looking decidedly less so in England.
A week or so later, reception called to say a package had arrived. I was relieved that this was likely to be the rug – I’d more or less given up any hope of seeing it or my money again. I was wondering whether the long roll would fit in my car when I was handed a small parcel about the size of a car battery. My disappointment was palpable. I took it home where it sat for two days waiting for me to summon up the will to open it and reveal just what had been sent to me. Inside, folded incredibly tightly, was our rug. The creases fell out almost immediately and, while it is slightly smaller than I’d remembered, it’s very soft and looks great. I was really pleased – I’d trusted Delhi’s Del Boy and been proved right to do so. He must have come across as credible!