As shown in our December 2013 Advisor Perspectivesarticle, the history of public companies and their investment outcomes demonstrates how various styles of investing have worked over time. Strategies in which an investor buys shares in good companies mired in high pessimism (and therefore offered at low prices) bubble their way to the top in terms of persistent, long-term performance. By adhering to these types of contrarian or value-oriented strategies, investors can perform consistently and remarkably well across long periods.
No other strategy even comes close.
How could it be that the strong performance of contrarian-style strategies persists over time? One would expect that as the secret got out, more would convert to this style of investing and gradually compete away the opportunity for excess returns. Yet the secret has been out for a long time. Graham and Dodd wrote their seminal book on value investing 80 years ago. Since then, many studies have noted the persistent performance of value-oriented strategies, and the impressive track records of its practitioners have been impossible to ignore.
Nonetheless, the opportunity to generate solid long-term investment returns from these types of strategies endures.
Why does this persistent opportunity to outperform via value strategies exist? Should we expect it to continue to exist? Research in behavioral finance and our own Investment experience offer some answers.
Behavioral finance
Market prices are directly influenced by human behavior, because price is established by investment choices. Humans have many increasingly well-understood biases and cognitive flaws that result in predictable errors in how we evaluate investment opportunities.
It is not very interesting that humans can be “predictably irrational” (to borrow Dan Ariely’s phrase). If individual investors behave in uncorrelated ways, then individual misjudgments might cancel each other out, resulting in an efficient, wisdom-of-the-crowd market where price and value rarely diverge. However, such an efficient market is fantasy. It is not what we have observed in the historical record or encountered in our own investing.
Instead, we have witnessed investors collectively and repeatedly focusing on developments other than companies’ operating results. When investors do this, companies’ share prices and intrinsic values can materially diverge, creating opportunities to profit when price and value eventually reconvene. Therefore, of the many behavioral finance topics that explain why individual investors make bad decisions, we discuss a few that explain why investors often (mis)behave in the highly correlated manner required for great investment opportunities to emerge.
Recency bias
One well-established behavioral bias is the tendency to give greater weight to more recent experiences than those from longer ago. Wikipedia provides a simple example of how this bias affects people in their everyday lives:
If a driver sees an equal total number of red cars as blue cars during a long journey, but there happens to be a glut of red cars at the end of the journey, they are likely to conclude there were more red cars than blue cars throughout the drive.
This bias makes it very difficult for people to appropriately understand and navigate the perpetual, but irregular, cycles that markets, economies and companies go through. Ray Dalio, founder of the hedge fund Bridgewater Associates, captured this fact well in his recent video How the Economic Machine Works. Dalio used an image resembling the following one:
Because recency bias is a fact of human nature, our default reaction is to over-respond to new information. When things are going well, we tend to expect them to continue going well. The flip side is also true. When good companies end up on the operating table for some reason (missing earnings estimates, a departing CEO, a failed product launch, a new regulation going through Congress, etc.), investors often assume that because things are bad, they can only get worse. In this context, investors become blind to the possibility that when a company is surrounded by pessimism, it might adjust and operate in the future as well as or even better than it did in the past.
This bias binds investors into groups. Investors live in the same market, read the same news and have a common set of recent experiences that color how they interpret new situations. In 1999, most investors saw only the opportunity for profit. In early 2009, most saw only the opportunity for loss. These are a few simple examples of investors’ recency biases playing out in highly correlated lock step and the crowd’s collective action ultimately proving unwise. In these and many other instances (which often occur at the micro level of individual companies and industries), investor actions set market prices that materially diverge from the intrinsic value of individual companies.
The evolution of humans and the (mis)perception of time
Recency bias is only one of many aspects of our mental wiring that have been refined and inherited from our ancestors. It is useful to examine the context in which humanity evolved to appreciate other ways we may be wired to collectively make bad investment choices.
Humans have been evolving for at least four million years. For almost all of that time, humans lived in hunter-gatherer societies, in which survival of the fittest meant being the best at navigating the day-to-day needs for food and protection. Only during the past 10,000 years, with the development of agriculture, have our ancestors lived in complex societies where the ability to think long-term and plan for the future is an advantage.
Here an analogy offered by Peter Bavelin:1 Imagine that all of human evolution was compressed into a single 24-hour day. Consider that 23 hours and 55 minutes of this evolutionary day occurred while our ancestors were living moment to moment, scrounging for food and avoiding predators. Only in the past five minutes have we progressed to the point where we are rewarded for thinking longer term and making the complex decisions that we are now confronted with every day.
The qualities that were advantageous during the vast majority of humanity’s existence still govern how we interpret the world around us. We seem to be wired to make fast decisions2, feel losses more acutely than gains3, and follow the herd4. After all, perhaps our own distant ancestors survived to reproduce our closer ancestors because when everyone around them started running, they — without thinking — began running too.
Investing implications
These behavioral traits are contrary to the long-term, contrarian mindset that allows one to profit from value-minded investment principles.
The human mind is wired to respond to threats second by second, but the fortunes and misfortunes of companies play out over years. During the month- or quarter-long periods when no new fundamental information on a given company emerges, investors are still bombarded with price fluctuations, general news, economic forecasts and others’ views. Human nature is to respond to this information. The idea that one should ignore it sounds preposterous to most investors, given how much time people spend looking at price trends, watching CNBC and seeking so-called expert forecasts.
However, as investors search for a signal in the noise that surrounds the stock market, they overreact and attribute too much meaning to information that proves to have little to do with the long-term value of their investments. This frenetic response to current developments causes prices to fluctuate widely around a company’s fundamental value. Time and again, this divergence becomes wide enough that value-minded investors can invest with a large margin of safety, with the probabilities of long-term success squarely on their side.
1. This analogy is adapted and borrowed from Peter Bavelin’s book Seeking Wisdom, From Darwin to Munger.
2. Part I of Daniel Kahneman’s Thinking Fast and Slow provides a great overview of the shortcuts we make when interpreting information and making decisions.
3. Daniel Kahneman and Amos Tversky’s work on Prospect Theory shows how humans tend to feel losses more strongly than gains. For an introduction to Loss Aversion, please see page 283 of Kahneman’s Thinking Fast and Slow.
4. Michael Price’s June 2013 article “From Darwin to Eternity” in Psychology Today provides a good perspective to the question of “To what extent can human herding be explained in terms of the same goals that motivate herding in other social species?”
Our own experience
Being human and possessing the same mental wiring discussed above, it has been thought-provoking to adhere to a systematic investment process that is unmoved by recency bias, unbound from experiencing time on a day-to-day basis and uninfluenced by the crowd. We have often found, in retrospect, that our instincts — if they played a role in our investment process — would have been counterproductive.
Our investment process uses machine learning — a discipline that draws on computer science, statistics and cognitive psychology— in an attempt to generalize from experience and learn in a similar way to how people learn. Machine learning may seem like a new concept, but you see its influence all around you today in book and movie recommendations by Amazon and Netflix, face recognition by Picasa, web search by Google, voice recognition by Apple and credit scores by Equifax. With regard to equity investing, our use of machine learning involved digesting the operating results and investment outcomes of public companies going back 40 years. The result is a quantitative basis for evaluating a current company’s operating history and market price in the context of the investment opportunities of the past that it most closely resembles.
When our process “likes” a company, it is because it has an operating history and market price that resembles other companies from the past that turned out to be fruitful investments. For each “liked” company, we write a short document reviewing why we find the opportunity attractive and why the market is pessimistic about the company’s future prospects. These documents do not influence whether or not we invest in the company. We write these documents to record our own views on the investment’s prospects for gain. If the company is our most highly rated opportunity, we make the investment regardless of our misgivings.
This is where we are confronted with a sobering realization: In general, the opportunities that have made us most uncomfortable have turned out to be better investments than those in which we were most confident.
Even after watching investors perpetually overreact to recent events and seeing great support for value principles in the historical record, our best investments would often have been the most difficult ones for us to make had we been operating on our own, without a commitment to a systematic process.
This is humbling, but it should not be surprising. We have the same recent experiences as other investors. We read the same newspapers. We have the same evolutionary history that has wired us to experience time and loss-aversion just as other people do. As a result, when great investment opportunities emerge because others’ pessimism is at a peak, our instinctive response is often the same as the herd’s: to be pessimistic as well.
Summary
Let’s return to the questions we asked at the outset: Why does this persistent opportunity to outperform via value strategies exist, and why should it continue to exist?
Value investing depends on the opportunity to buy good businesses when they are offered at bargain prices. These opportunities have emerged in the past and will continue to emerge in the future unless humans start acting in a very inhuman way — that is, if they patiently invest for the long-term and become immune to the day-to-day noise that has influenced investment activity across generations.
We see no evidence that this evolution is occurring. Human nature is one constant we can count on persisting over time. Technology innovation will surprise us, industry structures will change and regulations will evolve, but the basic elements of what it means to be human will not go away.
Mike Seckler and John Alberg are the managers and founders of Euclidean Technologies Management, a Seattle- and New York City-based investment advisor specializing in systematic value investing. Prior to starting Euclidean in 2008, John and Mike co-founded Employease, a software-as-a-service provider that Automatic Data Processing (NASDAQ:ADP) acquired in 2006. Both John and Mike graduated from WIlliams College in 1994.
