The Trough of Disillusionment

When a new industry or business emerges, it’s easy to get caught up in the hype and excitement. But how do you ascertain the actual value of a stock?

“The stock market is filled with individuals who know the price of everything but the value of nothing.”
– Philip Fisher

In the early 1800s, the Prussian Royal family urged its citizens to sacrifice their gold and silver jewellery in order to fund a war against Napoleon. In return for their valuables, the donors received jewellery made out of cast iron with the inscription ‘Gold Gab Ich Für Eisen’ — ‘I Gave Gold For Iron’.

Within weeks, these iron pieces became incredibly popular. They not only demonstrated that the wearer was wealthy but wealthy enough to sacrifice gold in order to help the war effort. Those who wore gold and silver were looked down upon as unpatriotic and cheap.

In his excellent article Have You Ever Tried to Sell a Diamond?, Edward Jay Epstein recounts that when the first diamond mines were discovered in South Africa in 1870, the financiers instantly discovered a problem — diamonds were actually pretty common.

So in order to protect their investment, they established a cartel to carefully control the supply of these precious stones, known today as De Beers. In order to fuel demand, De Beers spent millions on marketing diamonds as a necessary part of courtship and something that should be passed down through families for generations. They effectively coined the phrase ‘Diamonds are Forever’.

In the 17th century, newly introduced tulips became popular throughout northern Europe and saw extreme price inflation. At the peak of tulip mania (as it is now known), a single bulb was selling for around ten times the annual income of a skilled craftsman. Traders stockpiled the bulbs, hoping that prices would continue to rise. Though we don’t know the exact cause, over the course of a few weeks the prices of these bulbs crashed, ruining the fortunes of many speculators.

Perceived Value

Whether it be gold, diamonds, or tulips, the value of an object is fundamentally derived from what somebody else is willing to pay. Over the short term, the same is true for stocks. Stocks fluctuate wildly over the short term because what’s driving the price is perceived value and speculation.

This is most common with new technologies because often there is no telling what the long term value of some untested product is. There’s actually a rough graph that is used by Gartner to explain this known as the Hype Cycle.

Gartner Hype Cycle

Exciting new products often gain mass media attention at launch and the perceived value is inflated beyond what’s actually reasonable to hit the ‘Peak of Inflated Expectations’. Reality soon catches up, however, thus dropping it into what is referred to as ‘The Trough of Disillusionment’ before levelling out as the actual value is realized.

We saw this with solar power in the 1980s, and again with e-commerce during the tech bubble of the nineties.

Right now, it’s possible that bitcoin and related cryptocurrencies are floundering in their own ‘Trough of Disillusionment’ in the wake of the mania we witnessed in late 2017. The actual uses of the blockchain are now being explored and we are already starting to see some practical uses from the likes of JPMorgan Chase.

In the same vein, it could also be argued that the cannabis industry is ascending its own peak of inflated expectations, with crazy valuations being thrown around for companies that are, as of yet, really producing very little business. It wouldn’t surprise me to see a significant levelling out of expectations in the industry in the not-too-distant future.

Actual Value

Over the long-term, the value of a company tends to follow its earnings. A company like Alphabet, for example, is creating incredible value year after year. Every day, it’s paying thousands of employees, helping promote global business, and financing new technologies.

Is there much doubt that Alphabet will continue to grow and diversify its business? I would argue it’s almost a certainty (a word not thrown around lightly in the investing world), and this is what you should be looking for in a great stock.

People get flustered when it comes to investing because they try too hard to put concrete numbers on things that we can’t foresee with real certainty. They get caught up in all the noise and hype of financial news, failing to look at the actual facts and figures in front of them.

The most important thing to do is to identify great businesses that are creating value for all their shareholders — not just the investors, but clients, employees, and suppliers too. The value of these companies isn’t just measured by what someone is willing to pay for them. Instead, it can be accurately measured in actual money being created every day through products and services.

Often you’ll hear people complain that these stocks are expensive or overvalued, but that’s simply the price you pay for owning great businesses. Great management and visionary leadership come at a price, but the true value consistently reveals itself over time.

Companies that continue to adapt and innovative will always be a good buy.

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MyWallSt operates a full disclosure policy. MyWallSt staff may hold long positions in some of the companies mentioned above.