Now that financial Armageddon is apparently off the table and markets have begun to stabilize a bit, is it time for investors to get back to good old fashioned stock picking? In other words, going forward will bottom up analysis of individual securities again be more important than the top down, macroeconomic view? Of course any definitive answer to those questions would be nothing more than speculation. However, if is it the case that company specific fundamentals are more likely to drive share prices now that the volatility has subsided, investors would be smart to revisit a couple of biases that could lead to poor returns. Accordingly, over the next few posts I will examine some of these biases and how they often play out among stock market participants.
The first of these is anchoring bias. In a famous paper from 1974, behavioral scientists Tversky and Kahneman describe this bias in the following manner:
In many situations, people make estimates by starting from an initial value that is adjusted to yield the final answer. The initial value, or starting point, may be suggested by the formulation of the problem, or it may be the result of a partial computation. In either case, adjustments are typically insufficient That is, different starting points yield different estimates, which are biased toward the initial values. We call this phenomenon anchoring.
Tversky and Kahneman observed this behavior in a number of experiments conducted in the early 1970s. In the most well-known of these studies, the researchers asked participants to estimate the percentage of African countries in the United Nations. The results indicated that people anchored their answer to completely arbitrary numbers presented by the researchers. For example, the median estimate of people who were given 10% as a starting point was 25% and the median estimate of people who were given 45% as a starting point was 65%. Specifically, people became anchored to the percentage suggested to them by the question even though that number had nothing to do with the actual percentage of African countries in the UN. Having no knowledge of the exact percentage, people subconsciously took their cues from the numbers presented in the questioning despite the fact that those numbers were randomly generated.
Now, how does this bias manifest itself in the investing world? I think the main way in which investors can fall prey to this pitfall is by paying too much attention to the past prices of securities. The two most prevalent numbers that people seem to anchor to are the 52 week high and 52 week low for a stock. Setting aside technical analysis, in my young career I have observed a marked tendency for people to assume that a stock has potential to get back to its 52 week high but not breach its 52 week low. I think this is a reflection of the eternal optimism that exists in the market. On some level even short sellers believe that the market’s trajectory over the long run is more likely to be up than down. The problem with this thought process is that it assumes that those numbers are an indication of value and are not just random outcomes based on the whims of the market. In the end the value of a stock should be based on its earnings potential, a value that at certain times may have absolutely nothing to do with the current stock price. A quick look at the ride the Nikkei Stock Exchange has had over the past 20 years provides a sobering reminder that previous highs may never be reached again and stocks can stay at low nominal values for a protracted period.
Let’s take a current example to show how anchoring bias could really trip up an investor. This may seem like an extreme example but I think it illustrates very clearly the danger of becoming anchored to past prices. According to Google Finance, the 52 week high for Citigroup (C) was $23.50, reached in October of last year. From the current price of $2.78 Citi would have to appreciate by more than 840% to reach that 52 week high again. Could it get back there? Sure, but I think there are a number of things that will prevent that from happening for a long time (and maybe never). This is because the dynamics of companies are always changing and material events can occur that make previous prices completely irrelevant. In Citi’s case, the price in October 2008 obviously did not properly value the assets and future earnings power of the bank. In effect, the toll that the number of toxic assets on Citi’s balance sheet was going to have on earnings and solvency was not at all priced in at that point. Currently I think there are very few investors who would argue that the 52 week high reflected the company’s actual fundamentals or that Citi’s current earning power is anywhere near what is was during the boom period of 2005-2007 in which Citi averaged $2.90 in EPS. Therefore, that previous high may provide just as much information about the current value as the spin of a wheel provided about the percentage of African countries in the UN.
Furthermore, adding to Citi’s problems is the fact that in the future it is likely that the company’s return on equity (ROE) will be much lower. Just about every week in his market commentary, fund manager John Hussman includes a caveat regarding profit margins. For example, from his June 15th piece:
Stocks are modestly overvalued here, except on metrics that assume a permanent recovery to 2007's record profit margins (which were about 50% above the historical norm).
The implication is that companies were using leverage to increase profit margins and as the world de-levers, companies like Citi are not likely to be able to achieve the same margins going forward. This of course is compounded by the fact that Citi’s majority shareholder is now the US government. It is logical to assume that Citi will be under constant pressure to reduce leverage, limit risky but potential profitable behavior, and forgo some earnings to serve the nation’s credit needs. Finally, the fact that Citi’s share count has increased so much over the past year makes it much more difficult for the price to appreciate in a rapid manner. Just based on supply and demand there now has to be tremendous demand to move the needle on the stock price. Recently, many investors have not cared about dilution as numerous companies have raced to raise new equity. However, it is my belief that in the long run supply and demand fundamentals rule the day and that a company whose share count has increased as much as Citi’s has will have a harder time getting back to previous highs.
On the flip side of the anchoring bias regarding the 52 week high is the tendency to believe that a 52 week low represents some kind of durable bottom for a stock or index. These days the most common comment I hear has to do with the devilishly low 666 figure on the S&P 500 being the ultimate bottom of this bear market. I can offer no definitive wisdom about whether or not the fundamentals in the economy and financial markets will justify the index staying above its 52 week low. But, setting aside technical analysts and chart gurus, my concern is that some bottom up investors will ascribe some omniscient value to this figure and act on it. I personally don’t believe that the daily price of a stock or the value of an index consistently tells investors anything more than what Mr. Market is thinking on that day. All analysis of whether a price is too high, too low or just right has to be based on fundamentals. If people believe that at 666 the market is significantly undervalued based on the earnings potential of the companies in the index, then I have no problem with using a breach of that level as a buy signal. But to act as though the index should not go lower than 666 because that low was anything but a random number (like those that were presented to the research subjects of Tversky and Kahneman) is a recipe for disaster and substandard returns.
In conclusion, I would welcome the return of a time when the macroeconomic outlook did not completely dominate the direction of the market and individual stocks. While I am not sure we are there yet, it is still important for investors who are fundamentally oriented to remember that paying too much attention to past prices levels, earnings figures or profit margins without considering valuation is an example of anchoring bias that could skew a rational assessment of a stock or index.
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