C&B Notes

The Psychology Behind Unloved

In our latest quarterly letter, we wrote about the two types of businesses that tend to yield opportunities for us — undiscovered and unloved.  A recent article in MOI Global explores the behavioral economics (neuroeconomics) that support the search for investments among unloved and out-of-favor businesses.

In their investment process, value investors usually take an entrepreneurial approach, thinking as if they were the sole owners of the firm that they are analyzing. Most of them look for companies with businesses that are easy to understand, have solid and predictable cash flow generation, little or no leverage, good management teams whose interests are aligned with those of investors, high returns on capital employed and sustainable competitive advantages (or economic moats, as Buffett called them).  But the trigger that finally defines their decision to invest in a given stock is the possibility to pay a price that is sufficiently below their estimated fair value for the business, offering a margin of safety that serves as a protection against the potential mistakes that can arise in the analysis.

However, buying high-quality businesses, showing most of the characteristics mentioned above, at significantly low prices is an extremely difficult task.  In fact, it is almost impossible to perform under normal circumstances.  When a stock trades at low valuation multiples this is usually the result of a general perception within the investment community that something is going bad with the business.  When there is uncertainty regarding a company, most people prefer just to avoid its stock, as their brains have evolved to trigger a flight response from a potential danger, just as our predecessors used to do when they went hunting and suspected that a fierce animal could be nearby.

At this point, an in-depth fundamental analysis is needed to find value where others just see problems.  When faced with negative news, investors need to differentiate between companies in which the fundamentals have deteriorated forever from those where the damage is just temporary or the impact is much lower than the one discounted by the market (which tends to overreact).  Value investors concentrate their efforts in this second group, trying to find companies that have a strong competitive position in their industries and a solid balance sheet that guarantees they will survive after the storm (this is why most value investors prefer to avoid highly leveraged firms).  These resilient companies represent extremely attractive opportunities for the patient investor that has the ability to wait until things revert to the mean (or even improve further, if one manages to find antifragile companies as defined by Nassim Taleb).  However, for this process to be successful an in-depth fundamental analysis is usually not sufficient and the temperament of the investor will play a central role.  He or she will need to remain committed to his ideas against the general view of the other players in market, while being open to reviewing the initial thesis with humility if new confronting information appears.  Given the limitations of our brains in dealing with fear and stressful situations, a solid and easy-to-repeat investment process is crucial for those portfolio managers who decide to follow a contrarian approach.

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As we have already mentioned, our brain is a survival machine and it feels safer when we act as part of a group.  However, value investing requires portfolio managers to take a contrarian approach and to deviate from the crowd.  This is something that the large majority of individuals are not prepared to do, either because they are not able to overcome their own cognitive biases or just because they prefer not to put their professional careers at risk if they happen to underperform the market in the short-term.  This is the reason why, despite its recent growth, value investing will never be the part of the mainstream as, by definition, it implies doing things differently and buying undervalued stocks that other investors do not want to hear about.  Portfolio managers cannot expect to get extraordinary results by just betting with the consensus, because the information will already be incorporated in the market price.  To obtain superior results, it is necessary to deviate from the herding behavior and to follow our own analysis.  But we know by now that this will make our brain feel uncomfortable most of the time.

Indeed, even when the contrarian investor is right, there are usually not many people willing to celebrate the good news with him or her given that, by definition, most of the other investors were holding the opposite side of the trade.  Take as an example the film The Big Short (based on the book by Michael Lewis with the same title) and think about the words by the character of Ben Rickert, the retired hedge fund manager played by Brad Pitt and based on Ben Hockett in real life.  When his two young friends were celebrating the idea to short mortgage bonds and get extraordinary profits if the housing market collapsed, Ben cautioned them to temper their joy as they ultimately were “betting against the American economy”.  If they were proven to be right, “millions of people will lose their jobs” and suffer massive hardship of all kinds.  This idea about the intrinsic loneliness of the contrarian investor was also brilliantly summarized by Seth Klarman in the 2015 Baupost Group letter to clients: “You don’t become a value investor for the group hugs”.  However, the field of Neuroeconomics has shown that our brain likes the group hugs and is not designed to drive us comfortably through the road that can lead us to superior investment results.  This gives a huge importance to digging deeper into the understanding of our minds and to the design of strategies that allow us to benefit from the systematic mistakes of other investors while protecting our decisions from our own cognitive biases.


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