When Tremaine Atkinson, COO at LSV Asset Management (LSV), picks his stocks, he usually goes for the underdog companies. His strategy is to exploit investors’ biases toward popular or ‘exciting’ stocks, and buy overlooked stocks at low prices instead – and then watch them ride up.
With $18 bn in assets under management, LSV is just one example of an asset-management firm that uses psychology to accurately determine the value of a company. LSV takes what’s called a ‘behavioral finance’ approach to investing, which presumes that because investors are influenced by emotions and cognitive errors when selecting stocks, plenty of stocks are overvalued. LSV aims to isolate the psychological factors driving market values and then chooses stocks that aren’t overhyped.
If your company’s stock is undervalued, there may well be some behavioral finance asset managers in your stock today. And while it’s difficult, if not impossible, to influence their decision-making, it’s important for IROs to understand the mindset that drives this portion of the investment community.
For example, how do these investors determine a stock is undervalued in the first place? They start by isolating what drives overvaluation. According to behavioral finance theory, investors often pay too much for stocks that performed consistently well in past quarters. ‘People tend to take past growth rates and exciting stories about stocks and extrapolate that way too far into the future,’ explains Atkinson. ‘As a consequence they tend to get overexcited about companies with very high growth rates, and they tend to overpay for those companies.’
LSV steers clear of these stocks and goes for companies which were once over-valued but are now trading at low multiples. Apple Computer in the early 1990s is one such example.
‘The tech firm did fabulously in its early stages until it started to lose market share to Microsoft,’ notes Atkinson. ‘Investors basically gave up on the stock and it was trading at very low multiples but then Steve Jobs came back to the company and revitalized it. It took the market a long time to wake up to this so we were able to buy a company like that at very cheap multiples, while everybody else was off chasing really high-growth-rate stories.’
Untouchable
LSV money managers, like most behavioral finance managers, rarely interact directly with IROs and senior management because they fear that human contact could influence their investment decisions.
‘We tend to think it’s the IR person’s job to generate good feelings about a company so, from our perspective, that is not useful input into our investment decisions,’ Atkinson says. ‘It’s very difficult for [behavioral finance] investment portfolio professionals to really gain a lot by actively meeting with management because we think that people then get too influenced by subjective things.
‘Money managers might like the CFO or the CEO and say, Boy what a charismatic person, what a great leader, and fall in love with the company. They start thinking, This is a great company, and it may well be, but being willing to pay any price just to be in on that story – I think that’s a huge mistake.’
‘We rarely ever meet with management, because company management members in many cases give you an illusion of knowledge or an illusion of control,’ explains Arnold Wood, CEO of Martingale Asset Management. ‘They give you a sense that you know them better than you actually do.’ With $2.7 bn in assets under management, Martingale’s portfolio managers also base their investment decisions on behavioral finance principles.
But IROs and management aren’t the only people these investors are wary of. Sell-side analysts are also carefully scrutinized before their views are given credit. Wood says studies have shown people can’t focus on several things at once, so analysts who say they cover 20 stocks really only cover two or three closely. As a result, behavioral finance money managers will tend only to trust the information analysts provide on those two or three stocks they actively follow.
Wood also thinks analysts are often victims of the ‘touchy-feely’ syndrome, which drives them to favor stocks they have a personal connection with. In fact, studies have shown that analysts who visit with management usually develop more confidence in the stock. Therefore, behavioral finance managers are wary of how personal contact with executives can affect an analyst’s judgment.
Some behavioral finance investors use their evaluation of analysts’ behavior to make investment decisions. For example, when a asset manager believes an analyst is ‘anchored’ in his or her forecast of a stock, the asset manager might buy in.
Anchoring refers to when an analyst underreacts to a sequence of good or bad events, explains Meir Statman, professor of finance at the Leavey School of Business at Santa Clara University. For example, let’s say an analyst pegs a company’s earnings at $1 and then, as the quarter progresses, it looks like the firm might hit the $2 mark. If the analyst is anchored in his or her earlier prediction, he or she might not adjust his or her estimate fast enough. ‘Analysts who are anchored to the $1 [forecast] will adjust only to $1.10 or $1.20,’ explains Statman. ‘So the price will go up too slowly and, if you realize the nature of that cognitive bias, you can buy the stock early and benefit.’
Behavioral finance investors are also skeptical of companies that consistently beat earnings estimates by a penny or two, notes Wood. According to behavioral finance theory, senior executives who hold shares in a company often identify with shareholders and are driven to manipulate the numbers to present the best story.
‘That’s why you see so many companies coming in with one or two cents above the estimates,’ says Wood. ‘They want to beat the previous quarter so they might force receivables into the quarter or move payables to the next quarter to make sure that earnings are that little bit higher.’ What these behavioral finance investors look for are management teams that focus less on the company’s near-term performance and more on the long-term outlook.
Digging deep
According to Robert Shiller, professor of economics at Yale University, IR professionals would benefit from understanding behavioral finance because it offers an intuitive understanding of what motivates certain buy decisions. For instance, according to the theory, investors are inclined to buy stocks in companies that advertise or are constantly in the news. ‘Look at Microsoft,’ Shiller points out. ‘It has been the darling of the news media – Bill Gates is one of the most recognizable people in America – and that has certainly propelled Microsoft’s stock.’
Investors feel more comfortable investing in familiar companies. For this reason, IROs should make sure their company’s core message is easily accessible and not esoteric, Shiller recommends.
IROs should also market their stocks as a product, advises Statman. People are willing to pay for prestige and beauty and the same applies to stocks, he says. In fact, most investors tend to go for growth companies because intuition tells them they will make money, when really they should be chasing value plays.
But even if you’re not interested in studying behavioral finance, it’s a good idea to understand what motivates money managers who use this theory in their stock selection process – especially if your company is currently undervalued and you want to understand what motivates potential (or current) holders. Targeting these investors probably won’t get you anywhere because they willingly admit they rarely meet with senior management or IROs. But, like any other area of the buy side, it’s essential for IROs to understand what makes this portion of the investment community tick.
