January 26, 2012

Advisors’ Bad Behavior

Convincing advisors of the benefits of behavioral finance is ‘uphill battle’

Despite the large and growing body of research on behavioral finance and its role in the investment process, convincing most investment professionals of the merits of behavioral finance is still an uphill battle, according to Ralf Scherschmidt, portfolio manager of the $100 million Oberweis International Opportunities Fund.

“In the conversations we have with investment advisors, pension consultants and the like, there is still a resistance toward behavioral finance,” says Scherschmidt.

That’s because most investment professionals still hold tight to the efficient market theory. To them, the notion of human psychology and the idea that “humans actually behave like humans” remains a moot point, Scherschmidt says.

Scherschmidt, though, is a strong proponent of behavioral finance, despite the resistance he continues to face in convincing investment advisors and others of its importance, and his investment decisions rely in large part on insights gained from the discipline. He strongly believes that understanding human psychology is key to finding good investment opportunities, and the first stage of his investment process is based on the principles of behavioral finance, focusing specifically on the delayed reaction of the market to sudden changes in a company’s fundamentals.

“One of the strongest traits of the human brain is to stick with established beliefs,” Scherschmidt says. “Humans do not like change and they don’t like to change their beliefs. We take advantage of this in our investment process.

Scherschmidt has seen it happen time and time again that when a company’s fundamentals improve suddenly and significantly, leading to an increase in earnings that surprise the market, investors often struggle to immediately accept the change as they are biased by their previous estimates. His investment approach takes advantage of this “delayed reaction” behavior by buying the company’s stock before other investors adjust their prior expectations to reflect the new fundamentals, which then usually leads to higher stock prices.

“There is almost always a delayed share price reaction to an increase in earnings because people tend not to believe that the company is earning more and they need a number of data points to overcome the hurdle and change their beliefs,” he says. “By the time people have the confirmatory evidence they need to understand the change that’s resulted in an earnings increase and change their belief about the company, we are already ahead.”

Earnings increases are usually the result of a transformation, Scherschmidt says, so he looks for companies that have recently undergone some kind of a significant change --  one that will have a large impact on their business and future earnings potential, but whose share price is lagging the change because the market (buy side as well as sell side) cannot comprehend what has happened.

Banking on the time lag, Scherschmidt then switches gears to what he calls “the old school method” of in-depth, fundamental analysis, which entails thoroughly studying the company he’s selected, talking to its management and understanding the dynamics of its business, in order to value its future earnings.

“This research will take us a week or two to complete, but in a week or two, most people are normally still stuck in the old belief of what the company was valued at, unsure of what to do,” he says.

Scherschmidt gives the example of German company Duerr AG, which engineers and manufactures machinery for automotive production. He discovered Duerr stock on an earnings revision screen, he says, and knew that the low estimates analysts had for the company in 2009 and 2010 would not change quickly, partly because of the general economic recession, but also because of the “psychological phenomenon of people not wanting to change their beliefs.”

Scherschmidt took advantage of the time lag to do thorough research on Duerr, finding out that a new CEO who had come on board in 2005 was instrumental in refocusing the business around core activities, thereby poising it for the future. He also focused on understanding the competitive environment in which Duerr operates, the direction of the auto industry and where new business was being generated.

“Duerr had peak profit margins of 4% and no analyst was willing to give it more than 4% in the future,” Scherschmidt says. “We, though, came to the conclusion, based on the in-depth study that we did, that the benefits would be a lot higher.”

The market came to this realization much later and well after Scherschmidt had purchased the stock for his fund.

 

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