Lulled into Complacency
(Guest Commentary by Rick Konrad – August 22, 2008)
Dear Subscribers and Readers,
As promised – for those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary. Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month. Rick has also been writing for us for 18 months now. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick will be offering his thoughts on various sub-topics on behavioral finance – ranging from irrational biases such as loss aversion, the dependence on intuition as opposed to sound analysis, and over-confidence. He ends the commentary by suggesting a stock screen that would allow us to find “diamonds in the rough” in the current tough credit environment. As usual, Rick does not disappoint! Without further ado, following is a biography of Rick:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Stormy Weather” for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog. You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
As Henry has mentioned, I have been busy visiting clients and prospective clients for the last several days. As I look through many portfolios and talk to people, and unfortunately, as I look through my own mistakes, it becomes increasingly apparent that our behavior and decision-making are influenced by a wide array of psychological undercurrents. Unfortunately, many of these converge to become even more powerful.
The unwillingness to take a loss or loss aversion is one of the most powerful of these irrational behaviors. The word “loss” conveys a surprisingly powerful reaction in us.
In the book “Sway” Ori and Rom Brafman highlight one of the more irrational decisions that we make in life, taking out an extra insurance policy on a rental car at an astronomical rate just to be doubly safe.
“Companies like Avis and Hertz, facing the challenge of selling a product that is both useless and overpriced, have capitalized on this powerful effect. When we rent cars, our credit cards-not to mention our own car insurance-automatically cover us should anything go wrong with the vehicle. But the rental companies push additional coverage that is not only redundant but would cost us a whopping $5,000 on an annual basis.”
Similar thinking affects us in the stock market. Even when a profit could be nailed down but the stock has slipped below a previously achieved target price, investors frequently choose to ignore current data, put on their blinders, and proceed with a single-minded purpose to recover as much of what they perceive to be a loss as is possible. Irrational fears cause many investors to do what Peter Lynch of Fidelity Magellan fame described as harvesting the roses to allow the weeds to flourish…selling off small winners and hanging onto losers.
Clients do not see errors of omission, they do not see where we waited rather than acted. Holding on to the possibility that a stock may recover even though the facts seem to argue against it, is nothing more than the triumph of hope over reason. If this results in a loss, emotions get even stronger.
In my recent travels, I have run into many people who hold GM, GMAC, and/or Ford financial paper. Almost everyone that I ran into seemed more than willing to run the risk of ruin rather than take a loss. It is tragic to have to sell a two-year note that you had bought at an 8% yield for a current yield to maturity of 18%or 19% but it seems to me that prudence should dictate how you treat your retirement assets. Being committed to continue down the road that they had always walked makes it difficult to take a fresh perspective. Suddenly, a portfolio turns into a war of attrition rather than an attempt to earn superior returns. There are times when we are caught looking for that elusive light at the end of the tunnel. This brings to mind President Lyndon Johnson's lament about the Vietnam War:
“Light at the end of the tunnel, hell we don't even have a tunnel; we don't know where the tunnel is.”
Why must a problem escalate into a full-blown crisis before corrective measures are taken?
A recent paper by Katherine Milkman, Dolly Chugh, and Max Bazerman, “How Can Decision Making Be Improved” addresses some of our dealings with irrational biases. Psychologists, Keith Stanovich and Rich West made a distinction between what they termed System 1 and System 2 cognitive functioning. System 1 refers to our intuitive system which is typically fast, automatic, effortless, implicit and emotional. System 2 refers to reasoning that is slower, conscious, effortful, explicit and logical. The key to many better decisions is shifting yourself from System 1 to System 2 thinking.
Take an outsider's perspective. This will reduce your over-confidence about a decision that you have made or refuse to make. Consider the opposite decision or as Charlie Munger puts it, “Invert, always invert.”
Honestly now, knowing what you now know about one of your problem stocks, would you step up to the plate to buy it today? Avoid anchoring your thinking with what you paid for the stock…given today's fundamentals, would you be an owner?
In the end, investors need to focus on one priceless bit of advice from Munger: "All intelligent investing is value investing -- acquiring more that you are paying for. You must value the business in order to value the stock." Buy a business based on its merits only, not on what the stock price is or isn't doing. If you incorporate this businesslike mentality in your investing decisions, you'll do well over time.
Investors often rely on their own intuition. As one of the more memorable Wall Street analysts used to say to me, “I can feel this one in my bones.” The past 50 years of decision-making research challenges that reliance and trust. The more deeply we understand the repercussions of System 1 thinking, the more deeply we will want to reach deeper, more rational decisions.
One other anecdote. Sometimes there is a rose among the thorns. One of my favorite expressions is, “The obvious should not be an impediment.” The Washington Post ran an experiment about a year ago where a world-class violinist, dressed in jeans and wearing a baseball cap, played his Stradivarius in a Washington, D.C. subway station. He played some of the most challenging repertoire for violin known to man for free but no one seemed to care. The Post experiment counted over 1,000 people who just walked by. Unknowingly, commuters walking by attributed the value they perceived, the combination of baseball cap, jeans, and a subway station to the quality of the performance. Instead of hearing an outstanding concert, they heard busker's music…or they were in too much of a hurry to notice. Value attribution is our tendency to paint something with certain qualities based on perceived value rather than on objective data. Years ago, within a boring company called Parker Pen, lived a wonderful business called Manpower. Somewhere within the mess of the financial services industry live some decent banks that are not capital constrained. Even though the neighborhood may be ugly, there may be a jewel to be had. The price tag ain't necessarily the value.
More on the “obvious should not be an impediment.” Here is a screen (Word format) or (Excel format) that highlights listed American companies with the following attributes:
- Over $100 million in sales
- Debt that is at least 7 times as great as EBITDA generated over the last twelve months
- Return on invested capital below 10%
- Have an Altman score below 2.5.
The last point may need some explanation. The Altman Score (also called a Z-Score)is a test of the financial fitness of a business. It was invented by Professor Ed Altman, a finance prof at NYU who focused on predicting bankruptcies. Here is a link which can help you analyze the probability of bankruptcy for your holdings. It is also found in the financials tab of ADVFN.com.
Generally, an Altman score between 1.8 and 2.5 signals financial trouble. Below 1.8 suggests a high potential for bankruptcy, all things considered.
The markets have been very tough and sentiment has been dreadful, maybe not quite as dreadful as March of this year, but quite gloomy. Given the rather treacherous waters in which we navigate with crosscurrents of economic slowdown, this is not a time to attempt passage in a leaky vessel. Heavy debt burdens combined with low levels of profitability suggest trouble. Altman scores that measure productivity of assets, leverage, and working capital management can also confirm additional trouble. Most of these companies are not currently generating free cash flow.
Avoiding trouble is the first step to building a decent portfolio in these times. Obvious bargains may be part of bad neighborhoods and industries where most of us would rather drive past rather than through. Complacency about past decisions and hoping for something to come back is also prevalent. Hopefully, you can find some jewels in this wreckage. One place to start is with some Benjamin Graham bargains that we recently highlighted in Value Discipline. Please check these out at these links:
Value Discipline-Benjamin Graham Meets the Exchange Trade Note Part I
Value Discipline-Benjamin Graham Meets the Exchange Trade Note Part II