Behavioral Finance: Informational Inefficiencies Benefit Small-Cap Value Strategy

“We don’t understand why this delay occurs because there are very strong arguments that say it shouldn’t be happening, but one possibility is, of course, human conservative bias – people waiting for others to do something first,” Ikenberry said. “The fact that these behavioral anomalies exist and are stable, though, lead us to believe that we can base a reliable investment strategy on this.”

The Cozad team chose to focus on the small-cap space because it lends itself perfectly to the underlying behavioral finance research that Ikenberry has been working on for about 20 years.

“What we’re looking for are informational inefficiencies, and you’d expect that more as it relates to smaller companies that have less information out there in the public space and where fewer analysts are covering the stock,” Wetherell said. “That also means that many of our buys are in more boring industries – we don’t buy Amazon.com.”

Wetherell added that his team looks “to buy companies that are mispriced relative to their opportunities, so that puts us in the value space versus the growth space.”

The Cozad Small-Cap Value Fund employs a strict quantitative and qualitative due diligence process to drill down its investment choices to 120 names from an initial universe of 4,000 companies. Quantitative data helps identify the characteristics for which the firm is looking – value-oriented, strong cash flows, financial stability – Wetherell said, and qualitative assessment helps the team analyze to what degree the markets may be slow to realize the underlying value of a particular stock. Cozad assesses a management team’s conviction of the company’s market value and its commitment to shareholders by conducting a detailed analysis of its actions related to buybacks and dividend policy. Conversely, the firm looks to avoid those companies that are exhibiting information on equity offerings, dividend cuts and proxy fights, among others.

“From our inception, we have always said that we have two goals: delivering the most amount of behavioral alpha that we can benchmarked to the Russell 2000 and managing risk at a level that’s either equivalent to or less than our benchmark,” Wetherell said. “That means that in addition to behavior, we are also managing risk, so we take large bets in sectors rather than individual positions. We believe that this is a strategy that is effective in the long term, that it is stable and consistent, and that we can provide investors a very stable part of an overall investment strategy.”