Billionaire investor George Soros (Trades, Portfolio) is famous for many things, including his theory of reflexivity in finance. In an article in the Financial Times in 2009, Soros explained that he first started to develop this philosophy at the London School of Economics in the late 1950s. Over the next few decades, he refined and built out out the theory based on his experience of trading the financial markets and working with other business professionals.
Theory of reflexivity
The theory of reflexivity is based on two principles. The first is that in situations with many different participants, each participant's view of the world is always partial and distorted. This, as Soros described in his 2009 article, is the "principle of fallibility." The second principle is that these individual and distorted views can influence the situation to which they relate because false views lead to inappropriate actions. This is the "principle of reflexivity."
We see both of these principles in action in the financial world all the time. They become particularly apparent with companies that are suffering from financial distress.
Most companies have many stakeholders. Each of these stakeholders only has a limited view of the business and its operations. Shareholders may not have as much information as direct lenders such as banks, and banks may not have as much information as management.
This lack of clarity can result in a vicious circle. If shareholders start questioning a company's financial viability, its share price will come under pressure. Seeing this, suppliers may begin to question the company's ability to pay its bills, which could put pressure on cash flows, thereby raising questions at the bank and so on.
A stock and reflexivity
Investors must not lose sight of the possibility that a company's stock price can influence the value of a business due to the impact of reflexivity. This is something Seth Klarman (Trades, Portfolio) discussed in his book, "Margin of Safety:"
"Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital. When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy. If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy. The stock market says there is no problem, so there is no problem."
Klarman went on to give two examples. One was Citicorp stock, which in 1991 was trading in the mid-teens and was thus was able to find the buyers for newly issued securities to strengthen its balance sheet. However, if the stock price had been in the single-digits, "it would have been unable to raise additional equity capital, which could have resulted in its eventual failure," Klarman stated.
There was also the example of Mortgage Realty Trust in 1990. The company's low stock price shocked investors so much they were not willing to provide further funds to the business. It collapsed as a result.
So, while value investors are generally advised to ignore the market price action of stocks, sometimes it's worth keeping an eye on. Even if a business looks sound, a falling share price can quickly shake confidence. From there, it's only a matter of time before creditors start asking questions, demanding more collateral or squeezing payment terms. This can turn a healthy business into a weak one pretty quickly.
The best way to avoid this situation is to stay away from leveraged companies and enterprises, as these firms don't have to worry about falling share prices because they don't need to impress anyone. The company and the investor can focus on what they do best: collecting profits.
Disclosure: The author owns no share mentioned.
Read more here:
- Seth Klarman: The Importance of Liquidity
- Seth Klarman: You Need to Have an Edge
- Anatomy of the Bear: How to Navigate Bear Markets
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