In the second instalment of behavioural traps that active managers should avoid, Evidente argues that the costs of over-confidence out-weigh the benefits, recommends that portfolio managers should engage in DIY diversification rather than leaving it to corporates, and cautions PMs to not over-rely on DCF valuations.
In praise of being humble
A number of widely cited studies in the field of applied psychology document the above average driver effect, in which the overwhelming majority of respondents believe that their driving abilities are above average. Over-confidence or illusory superiority is not confined to self-perceptions of driving ability. Many people over-estimate their abilities, knowledge and future prospects compared to others.
Terrance Odean and Brad Barber have explored the effects of over-confidence in a financial market setting. They assert that over-confident investors over-estimate the precision and accuracy of their information, which lifts the likelihood that such investors trade too frequently based on their perceived superior information. The empirical evidence is not kind to over-confident investors; excessive trading is associated with inferior performance.
Odean and Barber also use over-confidence to link gender with trading performance. Female portfolio managers have superior track records than their male counterparts thanks to lower churning of their portfolios because they are less prone to suffering from over-confidence.
The key lessons are obvious; PMs ought to be more humble and trade less. Even when investors believe that they have access to superior information, they should be cognisant of the limits and costs to arbitrage, which can cause mispricing to persist for an extended time.
Ironically, the evolution in the structure of the funds management industry might actually reward over-confidence. Fund of funds and asset consultants are increasingly shifting towards a core –satellite approach to portfolio construction, where index and smart beta products are combined with high conviction/high tracking error funds. These funds typically require PMs to have a high degree of confidence in their stock calls, and be willing and able to take large active bets.
Overconfidence probably also contributes to the profitability of the betting against beta trade, which represents the poor returns from high beta stocks. Overconfident PMs – particularly those working in high conviction funds whose clients expect high returns - are more likely to buy high beta or cyclical stocks to generate outperformance. The strong appetite for such stocks lifts their price and drives down their expected future returns.
The world’s most successful investor appears to have intuitively long understood the benefits of betting against beta. In an academic article published recently (Buffett’s Alpha), researchers attribute Warren Buffet’s superior track record to his willingness and ability to use leverage to lift his exposure to low beta securities.
Don’t outsource diversification to corporates
In recent times, BHP announced a plan to spin-off its non-core assets into a new entity, South32, while Orica has sold its chemicals business to Blackstone after undertaking a strategic review of operations. These announcements come not long after Amcor and Brambles undertook major restructuring, spinning off Orora and Recall respectively, while Tabcorp and Fosters have also completed demergers in recent years.
The trend towards greater corporate focus has had a long gestation period and is a welcome development. Long gone are the days where it was common practice for firms to undertake mergers and acquisitions in unrelated industries to boost flagging growth prospects. Growth prospects for many diversified enterprises have simply not met expectations with the failure stemming from a lack of management focus and the inability of internal capital markets to allocate resources efficiently across often disparate and unrelated business units.
Yet some investors continue to have a strong preference for conglomerates on the basis that diversified firms offer defensive attributes and are not forced to rely on at times fickle capital markets to raise funds.
The tendency to believe that that conglomerates represent ‘safe’ diversified firms stems from the availability and representative heuristics. Some investors have a high familiarity with the strong track records of better known conglomerates with high profile CEOs, including GE and Wesfarmers, which have shaped investor perceptions about the benefits of corporate diversification (despite the fact that GE has performed dismally since the financial crisis). From this small but highly influential sample, some PMs extrapolate and assign these attributes to other diversified firms.
The trend towards corporate focus and strong performance from focussed and less complex firms confirms that financial diversification has won over corporate diversification. PMs who wish to participate in diversification benefits should do it themselves rather than out-sourcing to corporates.
Over-estimate the precision of DCF valuations at your peril
Price targets and DCF valuations have taken on a tremendous amount of importance amongst sell-side analysts over time. Changes to recommendations are often supported by the price of a stocks being significantly higher or lower than the analyst’s target price, which is typically based on a DCF valuation.
Modelling a DCF valuation can offer a sell-side analyst a competitive advantage. A detailed and granular model provides scope for sensitivity and scenario analyses, which some PMs have a strong appetite for.
But the long duration of stocks means that DCF valuations are awfully sensitive to inputs used, including the perpetuity growth rate and discount rate. To illustrate, I use the Gordon Growth dividend discount model (DDM) which says that the price of a stock is equal to its prospective dividend discounted at the rate of the discount rate minus the perpetuity growth rate in dividends.
The standard approach is to use the Capital Asset Pricing Model to calculate the discount rate, which equals the sum of the risk free rate and the product of a stock’s beta and the expected equity risk premium.
The chart below depicts the non-linear relationship of the DDM valuation (vertical axis) to variations in the discount rate (horizontal axis). The orange line corresponds to a high growth stock, and the blue line corresponds to a low growth stock. Both stocks are assumed to pay a dividend of $5 in the next period.
For the low growth stock, a small increase in the discount rate from 6% to 8% is associated with the DDM valuation halving from $250 per share to $125! The relationship becomes flatter or less sensitive at higher discount rates. But even a lift in the discount rate from 14% to 16% reduces the DDM valuation by close to 20%.
The steepness of the curve for the high growth stock confirms that the DDM valuation is even more sensitive to changes in the discount rate. A rise of only 50 basis points in the discount rate to 9% is enough to reduce the valuation by half to $512. To put the discount rate effect in perspective, subject to the assumptions used for the risk free rate and risk premium, a tiny rise in the stock’s beta from 0.8 to 0.9 is enough to generate a 50 basis point lift in the discount rate to 9%.
Insights from behavioural finance can help shed light on why sell-side analysts continue to rely heavily on DCFs in their decision making process, despite the sensitivity of inputs used. First, the DCF valuation framework is considered by many to be more intellectually rigorous than other valuation techniques, including price to book and price to earnings ratios. Second, the availability heuristic causes people to turn their attention to what is directly observable. It so happens that the output of the DDM is easy to interpret and directly observable, while the inputs are not. Third, the view that a stock has an intrinsic value helps to anchor our expectations and filter out what we consider to be irrelevant information. Fourth, when billions of dollars are at stake, stakeholders assign a greater level of precision to DCF valuations than is warranted thanks to the institutional setting.
In short, PMs should be wary of sell-side analysts who bang the table with a high conviction buy or sell call based on their DCF valuation. Over-estimate the precision of DCF valuations at your peril, particularly for high growth stocks.
In the third instalment of this series, Evidente highlights the importance of seeking out independent and alternative sources of information to generate sustainable alpha, argues that price gaps do not necessarily amount to burst bubbles, and warns of the tendency and costs of riding losers for too long and selling winners too early.