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Most People Aren't Wired Right for the Markets

by in Trusted Advice

It seems every time a stock or asset class starts appreciating in value the chattering classes start talking about bubbles.  Manhattan, or Hoboken real estate set record prices - bubble.  Private equity companies valued at over $1 billion - bubble.  While these and other examples may be overvalued, there is a big difference between overvalued and bubble territory.  At it's bubble-icious peak in March of 2000, the Nasdaq traded at something like 175 times forward earnings.  Today the Nasdaq 100 trades for around 22 times forward earnings.  The index levels may be simlar, but the valuations are definitely not.

So why does this happen?  It turns out most of us just aren't perfectly rational like classic economic theory maintains.  The relatively new field of behavioral finance (since the 1970's) tries to sort some of this out and has identified many biases that can really hurt investors.  The reason everything seems to look like a bubble to people now is due to the 'availability heuristic' (or mental shortcut).  This is the human tendancy to overestimate the likelihood of events with greater "availability" in memory, which can be influenced by how recent the memories are or how unusual or emotionally charged they may be.  As an example people tend to buy more flood insurance if they, or their area, has recently sufferred a flood (Hurricane Sandy), or there has been intense media coverage of a flood somewhere (Hurricane Katrina).  And for most investors, the Nasdaq bubble and crash and the real estate bubble leading up to the 2008 market crash were both relatively recent and highly emotionally charged. 

Studies have uncovered many more such heuristics and biases, such as overconfidence (90% of all drivers believe they are above average), confirmation and hindsight bias (selectively filtering things that support your opinion and leaving out those that don't) and anchoring (attaching to some reference point).  These are all short cuts the brain develops to cope with the world, whether we are in Westfield, or Westwood.  We are all subject to them, the key is in recognizing them and then acting accordingly.  Used properly, you can even turn these biases to your advantage.

At Covenant, we try and take advantage of the anchoring that happens when growing companies outperform their earnings estimates.  When a company beats earnings estimates, analysts must then consider whether to raise estimates for the rest of the year.  If it appears sustainable, they tend to increase those estimates.  However, often times because of anchoring, they also tend to not increase them enough.  They are still attached subconsciously to their old growth and earnings estimates.  This gives investors an opportunity to buy something that is growing faster than most people expect at a lower valuation than is perceived. We all do this, everyday and often anchor on numbers or facts, that have nothing to do with the question at hand, just to give us some sort of reference point.

Anchoring example

For example, a company is trading at $24 a share.  It recently introduced some new products and growth has begun to really accelerate. So earnings are estimated to be $1.20 per share this year, up 20% from last year.   So the market as a whole believes it is fair to pay 20 times expected earnings (P/E) for 20% growth.  However, if the analysts have not increased the estimates enough because the are anchored to their old estimates, and instead the company turns out to earn $1.40, then instead of having paid a 20 P/E for 20% growth, the investor would have paid a 17 P/E for 40% growth.  A bargain.  And this doesn't even take into account the effects on future years earnings.  As the quarterly earnings are released and estimates beaten, it can take a long time for the analysts to catch up.  At Covenant, such sustainable growth that the analysts haven't quite caught on to the magnitude of, is just one of the things we look for in a stock investment for our client portfolios.  While studies have shown that this works for individual stocks, in 2003, a study by Kothari (M.I.T.), Lewellen (Dartmouth) and Warner (Rochester) showed that this effect does not hold for aggregate data.  So while we at Covenant can take advantage of this because we invest in individual stocks, portfolios using broad market based funds have one less arrow in their quiver.

 

 

 

 

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Guest Sunday, 23 February 2020