The managers of the TAMIM Australian Equity Small Cap Individually Managed Account (IMA), take a look at the importance of understanding the psychology of other players in the market and reveal where they look to gauge what others are thinking and how this informs their investment decisions.
Gauging Market Expectations - February 2017 -
Understanding what the market is expecting from a company is a key input in our investment process. We are looking for under-appreciated stocks where the valuation reflects the market’s low expectations for the business. As a result, we look to gauge market expectations before investing and look to forums, broker reports, investor discussions and subscription research services to better understand what the market is really expecting from a company. In our experience, understanding behavioral finance allows for a more accurate interpretation of market commentary.
Start with the stock’s valuation:
The market’s opinion on any given stock is clear for all to see in the form of the current stock price which in theory represents the current value of expected future cash flows. As a result, we view a stock’s current valuation as a great starting point in gauging what the market is expecting from a company looking forward.
As passionate value investors we are always looking for stocks which are trading significantly below their intrinsic value, which encapsulates that company’s future cash flows discounted back to a present value. Stocks which trade well below their intrinsic value generally do so because their shareholders have low expectations of future cash flows, and thus value the business accordingly.
As a result, gauging market expectations is a key part of our value investment process.
The smaller companies market is inefficient:
One of the great attractions of investing in smaller companies is the inefficient nature of the smaller companies’ market. There are far fewer analysts and investors looking at each stock at this end of the market, which creates a significant opportunity for smaller companies’ investors who are prepared work hard to fill in the information gaps themselves. These market inefficiencies mean we need to work harder than just looking at the stock price to gauge what the market is really thinking. We need to listen to the market...
Listen to the loudest opinions and take them with a grain of salt:
We are believers in the power of using behavioral finance to your advantage when investing. In our experience listening to market voices can add significant value when gauging market expectations. However, not for the reasons you may think.
Any psychology graduate will recognise that when people are expressing particularly loud and strong opinions about something there is generally a deeply held personal reason for it. In our experience, when someone is talking particularly positively about a stock, it generally means they are invested in the stock and are thus comfortable to “talk the stock up”. And conversely, when someone is negative about a stock, it generally means they aren’t invested in that stock and thus feel comfortable to “talk the stock down”, possibly so they can buy the stock at a lower price in the future.
Knowing why people are broadcasting their opinions can be a useful tool when gauging market expectations, particularly in the small world of smaller companies investing. If, for example, five of Australia’s leading smaller companies fund managers are all invested in the same stock (which is incidentally a more common occurrence than you may think!), and have all published positive research updates recently, the chances are high that expectations are high. Those five fund managers are likely to have already built their positions in this stock, and by broadcasting their opinions loudly across the market, the chances are high that some retail investors have followed the “smart” money into this stock as well. In this scenario, we would be cautious regarding the stock’s short and long term potential knowing that the incremental buying is likely to slow down looking forward, and also that once that happens some of the more short-term focused retail buyers are likely to sell down once the stock starts under-performing, leading to further under-performance.
By knowing that expectations were high in this example, an investor would have been in possession of a significant advantage versus the broader market.
Where are the loud voices to be interpreted?
We pay attention to the opinions from across the market and see 4 main communication channels as worth factoring into expectation analysis:
Read stock message boards like Hotcopper – Hotcopper provides a fascinating insight into what people want you to think they are thinking, and provides a forum for the loudest opinions to be broadcast across the market. In our experience, stocks which have many Hotcopper postings each day tend to be followed closely by short term focused investors/traders. The more people are discussing a stock, the more they are generally hoping from that stock in the short and long term, and vice versa. We tend to be invested in stocks where there is minimal commentary on Hotcopper since few people follow or understand them.
Talk with other investors – Similarly to Hotcopper, it is interesting to talk with other investors and take what they are saying with a grain of salt. Of particular interest to us is when many investors are talking about the same stock/s, which tends to indicate expectations are rising.
Follow broker analysis – At the smaller companies end of the market it is generally uncommon for brokers to write regular research updates so following broker research can be of marginal use. However, in the rare cases it does happen, we are aware that expectations may be rising as a stock continues on its journey from undiscovered to discovered.
Follow subscription research services like Motley Fool – Some of these subscription research services advise many thousands of investors, and they are often looking at the smaller companies end of the market. It can be worth being aware of their recommendations in stocks you are following because they can significantly impact upon expectations and the type of shareholder on the register.
Management engagement and communication
We have noticed that management communication is also very important when gauging market expectations. There is a spectrum of management communication styles across the market, and in our experience management teams which focused on under-promising and over-delivering tend to do just that. And they also tend to attract stable long term shareholders who are taking a truly long term view on the investment, rather than aiming to trade in and out around results. In our experience this is the ideal type of shareholder register to support long term value creation.
We encountered an interesting example of management communication behavior we aim to avoid recently when we noticed the CEO of a company we were analysing (who will remain nameless) was communicating directly with investors through Hotcopper on an almost daily basis. The following quotes are indicative of his communication style:
"It's time to put your seat belts on and enjoy the ride and for those that got in at these price levels...... well done!"
"Further news flow should see this break out."
Needless to say the stock has attracted a highly speculative and short term news-flow focused shareholder register. We believe this may create challenges for the stock’s short and long term outlook as expectations are already high, with many shareholders in a hurry for results.
Use the noise to ultimately ignore the noise: Think long term:
Buffet’s famous quote couldn’t be more accurate in our experience. Markets will always be driven by greed and fear, and it is only by mastering our emotions as investors that allow ourselves to be exposed to significant wealth creation opportunities in the equity markets.
We believe being aware of market expectations and the behavioral finance implications are powerful tools investors can use to ensure they are exposed to the right type of stocks which they are able to think long term about, and ultimately ignore all the short term noise.
Gauging expectations is core to value investors’ psyches since we are looking for stocks which are largely ignored and under-appreciated, and thus under-valued. Low expectations is near the top of our shopping list of the attributes of high quality, under-valued smaller companies we are looking for. We will continue to focus on stocks where expectations are low.
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