Volatile Stock Prices: Avoid Downward And Upward Overreaction – Part II by Steven De Klerck
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In the first part, we have learned that investors better disassociate from the often volatile stock prices and should focus on the impact of price fluctuations on equity valuations. Realizing this insight however does not imply that most investors also will act in accordance with this knowledge.
In this context, I often present the following graph to investors. The graph shows annual returns to a traditional value investing strategy (refer to the section “Valuations”) in US large caps over the period 1969-1974. Here, it should be noted that at the end of the sixties the valuation of the US stock market from a historical perspective was high. Otherwise said, the inferior returns in the following years should not come as a surprise. Over a period of six years, value investors have lost 35% of their initial investment. Over the same period, a traditional growth strategy experienced a decline of 45%.
Appetite for equity investments following these returns or for an investment strategy with the aforementioned track-record usually seems to be far away for any investors. Fear for (apparently) negative circumstances and the corrections involved and fear for further corrections often are so strong that investors psychologically are unable to act rationally in function of declining stock valuations. Investors forget about valuations and overreact on the downward trend in the past years, leading to inferior returns.
Investors who maintain the focus on valuations, reach the same conclusions as Benjamin Graham in 1974. Hence, the attractive returns in the following years are simply the result of acting based on these conclusions.
I can assure the reader that among the 500-odd NYSE issues selling below seven times earnings today, there are plenty to be found for which the prices are not “correct” ones, in any meaningful sense of the term. They are clearly worth more than their current selling prices, and any security analyst worth his salt should be able to make up an attractive portfolio out of this “universe.”
Benjamin Graham, 1974
The above example deals with a downward overreaction on negative returns over the preceding years. A similar, unfortunate overreaction can be seen when investors need to choose from two or more investment strategies. In most cases, the strategy with the highest returns over the preceding years is selected, again in the assumption that these returns will continue to be seen in the following years.
In this field, we already have elaborated on the example of value versus growth investing around the turn of the century in the “Valuations And Stock Returns: Looking Back on The Dot Com Period” article. Investors neglected value stocks and extrapolated the extraordinary high returns of growth stocks over the period 1998-1999 towards March 2000. In the following years, this overreaction was severely razed. Preferably, investors should think twice before taking a chance with strategies with significant outperformance over the past years.
A third example of overreaction can be found in the field of selecting equity funds by investors. In “Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies“, Hsu et al. (2014) compare the returns realized by investors in equity funds with the returns realized by fund managers over the period 1991-2013. The results are shown in the following table.
The first column “Dollar-Weighted Return” shows the returns realized by investors in various types of funds. The second column “Buy-and-Hold Return” indicates the return realized by the investment fund. For all types of funds, the return difference is significantly negative. Investors destroy annually on average 2% of the buy-and-hold return.
The reason is that investors get into equity funds after high equity returns/outperformance over the past years (upward overreaction) and unload equity funds after low equity returns/underperformance over the past years (downward overreaction).
Investors overextrapolate from recent fund performance and mistakenly forecast high future returns instead of low future returns.
Hsu et al., 2014
Similar findings for professional investors of among others pension funds can be seen in “Absence of Value – An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors“.
Similar to what we have seen in the previous contribution, the advice is to focus not on price fluctuations but on the impact of price fluctuations on valuations. This is perfectly practicable for every investor in the first two examples. When investments in equity funds are concerned, it is a lot more difficult for investors to get an insight in the valuation and the evolution in valuations of the stock portfolio through time. As mentioned at the end of Part 1, within Pure Value Capital we will always communicate in terms of the price-to-book ratio of the optimal value portfolio.
“Only performance fee for investors with a time horizon of five years and more.
The cause of investors’ significant underperformance in equity funds is partly to be justified in the way in which asset managers are compensated.
When compensation mostly is done via a constant annual management fee, strong performances over the past years are logically used as a marketing issue in order to attract additional assets under management – of course without mentioning that chances of continuing this outperformance over the upcoming time periods are rather small. In this context, please also refer to “Hiring Good Managers Is Hard? Ha! Try Keeping Them“. Otherwise said, asset managers exploit the predictable overreaction of investors. The result can be guessed: returns for the new investors that are significantly lower than the buy-and-hold returns.
When only taking into account a performance fee, the manager is forced mainly to attract new assets under management following underperformance and/or negative returns within certain strategies, viz. the time periods when expected future stock returns are highest. In light of the results in the above table, this is at least a challenging objective. There is no doubt that realizing this objective definitely requires clear and consistent communication through time, both in terms of valuations and in terms of the way in which asset managers are compensated.
Hence, for investors with a time horizon of five years and more, within Pure Value Capital we will only take into account a performance fee with high-water mark. In plain words: when the manager does not realize consistently strong returns for the client, he will not be compensated. In this way, we create an incentive structure where the interests of the asset manager and the client are perfectly aligned. This incentive structure should contribute to a substantial reduction in the observed gap between the returns realized by investors and the buy-and-hold returns, and preferably even that this gap will become positive.
In this section on “Mental approach”, we departed from two perceptions about equity investments adhered to by many investors.
First, investors are convinced that stocks are risky or highly risky. This perception stems from both the risk of a permanent loss of capital and the high volatility of stock prices. Stocks are considered as “too unpredictable and too risky”. Regarding this first bias, we have seen that stocks fundamentally are much less risky than usually perceived based on the observable volatility. The advice was to optimally gain from this volatility with valuations being a precept.
Secondly, investors consider stocks and equity funds as (un)attractive after periods of (weak) strong performances, in the assumption that these performances will continue to be seen in the following years. Investors suffer from or show upward and downward overreaction. We have seen that this bias results in significant underperformance for these “naïve” investors. Here, the advice should be to get rid of the ruler where investors extrapolate returns to the upcoming years and to refocus on the impact of price fluctuations from the previous years on equity valuations.