How to Take Advantage of Irrational Stock Buying

Oberweis International Opportunities Fund manager uses behavioral finance in stock-picking strategy

Ask Ralf Scherschmidt if it’s a bad idea to invest right now in European or other foreign companies, and he’ll tell you that most people are seriously underinvested in international small-cap stocks because their emotions are telling them to stay away from the global markets.

The Oberweis International Opportunities Fund (OBIOX) portfolio manager is bullish on Japan, Europe and the U.K. because his stock-picking strategy that uses a combination of behavioral finance and fundamental research has shown him those regions are rife with opportunity.

Ralf Scherschmidt, Oberweis International Opportunities Fund (OBIOX)Scherschmidt’s (left) fund performance year to date totals 17.45% versus recent Lipper Award international small-cap winners Templeton Foreign Smaller Companies Series (FINEX), at 17.06%, and Oppenheimer International Small Company Fund (OSMAX), at 10.66%.

“The fact is that investors can be emotional and they take their money out of the markets at a bad time, which is when the markets are down, but that’s the time to buy,” Scherschmidt said Tuesday during an interview with AdvisorOne in New York.

The German-born Harvard MBA credits his study of behavioral finance, which he says proves that the traditional belief in efficient markets mistakenly presumes that investors act rationally and without emotion.

Post-Earnings Announcement Drift

 “The efficient market hypothesis is wrong, and we take advantage of inefficient stock market anomalies, called post-earnings announcement drift,” Scherschmidt said.

Post-earnings announcement drift, or PEAD, is a phenomenon that caught fire after first being reported in 1968 by University of Chicago accounting researchers Ray Ball and Philip Brown. Published in the Journal of Accounting Research, their findings stated that earnings surprises result in abnormal stock returns that drift in the direction of the surprise for weeks or even months after the earnings announcement.

“PEAD is the tendency of stocks that beat earnings expectations to continue to drift upwards for about two months after the announcement, or likewise for stocks that miss earnings to continue to drift downwards,” wrote Victor Bernard and Jacob Thomas in the same journal in 1989. “The abnormal returns associated with the drift are substantial.”

Scherschmidt, who also cites behavioral economics professor Dan Ariely’s book Predictably Irrational as an influence, says that he backs up his use of behavioral analysis with deep fundamental research that leads him to undervalued companies.

Small-Cap Opportunities Abroad

Non-U.S. small caps provide more investment opportunities than domestic small caps in terms of number of stocks, at 2,609 companies versus 1,956, writes the Oberweis international team in a February white paper.  In terms of market capitalization, U.S. small caps are larger at $2.0 trillion versus $1.5 trillion for non-U.S. small caps, but while the U.S. small cap segment is larger, they assert, the international small cap opportunity set is large enough to support a stand-alone allocation.

“Ignoring international small caps as a category eliminates a tremendous number of companies from around the world from the available investment opportunity set,” the Oberweis authors write. “Furthermore, the non-U.S. small cap segment should continue to grow as a percentage of global market capitalization.”

The Oberweis International Opportunities Fund’s top holdings as of Dec. 31 include Duerr AG, a German auto parts manufacturer; Gree Inc., a Japanese Internet media and social games company; and Ashtead Group PLC, a British equipment rental firm.

Read more about Dan Ariely and behavioral finance at AdvisorOne.

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