Investment theory is based on the markets efficiency principle whereby all available information is already built into all stock prices. Too often behavioural biases prevent investors from achieving their investment goals. We'll explore how these biases influence decision-making and, in turn, prices.

We will then uncover how the Threadneedle American strategy's investment philosophy and process are designed to identify and profit from these behaviourally-induced mispricing opportunities.

Behavioural biases

Investors' decision-making is influenced by emotions such as fear and greed. As a result investors do not always act rationally. Let's explore some of the more common behavioural biases:

• Overconfidence: where we tend to rate our abilities higher than we ought to and can be overly optimistic about the stocks we pick or pessimistic over those that we underweight.

• Loss aversion: where we are naturally more sensitive to losses than gains. Investors tend to feel the pain of bearing a loss much more acutely than they do the satisfaction derived from an equal and opposite gain. For example, the sense of loss we would feel from losing $100 is said to be far greater than the pleasure we would get from finding $100 in the street. In the same way, investors can struggle to recognise a loss and fail to sell a stock whose fundamentals are deteriorating in the hope of breaking even in the future.

• Inertia or status quo: whereby an investor will not proceed on their chosen course of action because of a desire to avoid making a decision or prompting an undesirable outcome, and will instead 'wait and see'. This delay can hamper effective decision-making. We see this when analysts do not change their numbers or ratings to reflect a change in the fundamentals of a stock. Likewise, traditional fundamental fund managers tend to be slow at reflecting changes in a stock thesis because of loss aversion or overconfidence.

• Anchoring: can be a powerful effect in which investors 'anchor' to certain targets, despite the fact that they are purely arbitrary. This often prompts investors to sell their winners too early. The price target is a number like any other but it can maintain a peculiar hold on some investors' thinking.

• Snakebite or 'once bitten, twice shy': In the same way that an unpleasant experience in life can induce caution the next time we face it, the same can apply to when we've had our fingers burned investing in a company. We are much less likely to invest second time around, regardless of whether that investment has become a very different proposition. It is a natural human response.

These are among many human biases and as such they are persistent and contribute to making the market inefficient.

Investment philosophy

Investors are not purely rational, objective and detached. They exhibit behavioural biases that affect their decision-making. This gives rise to persistent inefficiencies in the marketplace that we seek to exploit with a disciplined investment process that aims to deliver consistent alpha for our clients.

We believe that quality stocks, either cheaper than the market and/or with positive business momentum, tend to outperform.

Investment process

In line with our investment philosophy, we look at quality stocks that can be cheaper than the market and supported by positive business momentum.

We define quality companies as those with earnings sustainability and capital management discipline. This helps us avoid companies where management teams might make egotistic or empire-building investments that ultimately destroy value for the shareholder as measured by return on capital employed. Empirical evidence suggests that disciplined management teams tend to deliver superior returns.

We look at cheap stocks relative to the broad market and sector. We ask ourselves whether the stock is a value trap and what the market is pricing in. Because investors are overconfident, they are often too pessimistic about the challenges an out of favour stock is facing. We seek to invest in companies with improving business fundamentals (as measured by price appreciation and earnings revisions) whose managements have delivered consistent earnings and disciplined capital allocations.

Finally, we define business momentum as the combination of price momentum and earnings revisions.

Price momentum is important because investors are risk averse and tend to sell their winners too early. Evidence suggests that the trend is indeed your friend.

In regards to earnings revisions, sell side analysts tend to display "herding" behaviour, whereby earnings per share estimates cluster around the consensus. Sell side analysts are also slow to update their estimates in light of new information as they tend to anchor to their prior numbers.

The US team at Columbia Threadneedle Investments draws from a deep and broad resource encompassing the US and the UK, with 27 career fundamental analysts at the Central Research department based in the US actively covering around 650 US companies. The portfolio manager also benefits from the macro-economics and 'themes' insights. This offers us a differentiated insight which, in turn, informs better portfolio decisions.

Process in action

A buy example. In 2014, a new generation of video game consoles were hitting the market and we had a closer look at Electronic Arts (EA), which was recently under new management. The market had previously marked it down for underperformance versus its peers during the last 'console cycle'. But it was clear that we were at the onset of a new console cycle, providing top line acceleration, and that new management was keen on improving the gross profit margin by focusing more on digital download computer games over physical units. As such, it looked as though the difference in valuation versus peers such as Activision would narrow.

Once we got confirmation of the company executing on the growth prospects - as EA beat consensus estimates and raised guidance above expectations - we got involved with the stock. We have been holding the stock for over three years, holding on to our winner as sell side estimates are still not reflective of the strong fundamentals of the business. As such, we have had a succession of "beats and raises", and the stock is up roughly three-fold since we bought it, significantly outperforming the broader market¹.

A sell example. Another facet of our investment approach is being prepared to sell stocks, even if it means having to withstand the pain of a loss. This is because there are instances when we know that if the fundamentals have changed, then the stock price may have further to fall. We want to avoid being loss averse.

There have been examples in our portfolios where, having witnessed a change in the outlook for a company, we have sold the entire position, even if analysts are sticking with their buy ratings. It can be difficult to stand against the consensus but this is another example of where a dispassionate, objective approach can help to differentiate us from other players in the market.

We sold out of Southwest Airlines in July this year as we felt there was evidence for top line growth to decelerate and the multiple was getting rich compared to its historical average. This stock performed well for us over the 2.5 years we held it, outperforming the market during that time; but since we sold the stock it has underperformed the market².

Summary

We believe our approach confers three advantages for our investors. Firstly, we offer a genuinely differentiated, behavioural approach to a market in which we believe too many investors have thrown away alpha by adopting passives. Secondly, the alpha generated from a behavioural approach has low correlation with traditional style investing, offering a diversification benefit. And thirdly, we believe that the anomaly we exploit is persistent, as long as human nature does not change.

¹ Columbia Threadneedle Investments, 05.10.2017
² Columbia Threadneedle Investments, 05.10.2017

Download PDF