San Francisco Financial Planner, San Francisco Financial Advisor

Why do investors fall in and out of love with stocks at exactly the wrong time? Strong recent performance (“momentum”), fleeting fads and promises of huge growth potential are irresistibly compelling to inexperienced investors as they push their valuations up to unsustainable levels. After investors have experienced negative earnings surprises (which is inevitable), they overreact once more to the prospect of lower growth. What is the driving force behind this? Why do companies doing so well suddenly disappoint? Why do shares which outperform in the short term underperform over longer periods? The answers lay both in the allocation of capital and associated psychological biases or tendencies.

Companies do not exist in a vacuum. Their fortune is determined, to some extent, by the activities of other businesses. Relating a company to its environment is the essence of determining sustainable competitive advantage; which some believe is the prime determinant of investment success when combined with purchasing an interest below a conservative estimate of intrinsic value. In the book Competitive Strategy by Professor Michael Porter of Harvard Business School, he outlines five forces which influence a firm’s strategic position:

1. The bargaining power of supplies;

2. The bargaining power or buyers;

3. The threat of substitution;

4. The degree of rivalry among existing competitors;

5. The threat of new entrants into the marketplace.

Unless an enterprise if protected from these forces, then competition will serve to drive down the return on invested capital. In a free market, high returns on capital or the prospect of profitable growth will attract new competition.

When shares of companies trade at a premium to the underlying replacement cost of their assets, there is a strong incentive for managers to increase their capital expenditures. High valuations exert their influence on all participants such as the managers of public companies, owners of private businesses and venture capitalists. Private businesses may bring forward their desire to take their companies public...or venture capitalists will establish or finance enterprises where the stock market offers them the prospect of large gains. All of these actions increase both the productive capacity of the industry and the supply of shares available to the public.

By contrast, when companies in an industry fail to earn their cost of capital, share prices tend to decline. The market value in such an industry is likely to fall below the replacement cost of its assets. In this situation, there is little incentive to invest in new capacity. Instead, companies may react by cutting costs, merging with other companies or may simply exit the business. As a result of these actions, capital employed within the industry shrinks, supply increases at a lower rate than demand and the prices for goods and services supplied by these firms begin to rise. In time, the improvement in profitability and returns on capital of the remaining companies will be recognized by the stock market. If investors have been overly pessimistic during the downturn, the share prices may outperform during the recovery phase.

This was recognized in the early 1930’s and described by Benjamin Graham and David Dodd in their classic work, Security Analysis:

“A business which sells at a premium, does so because it earns a large return on capital; this large return attracts competition; and, generally speaking, it is not likely to continue indefinitely. Conversely, in the case of a business selling at a large discount because of abnormally low earnings, the absence of new competition, the withdrawal of old competition from the field, and other natural economic forces should tend eventually to improve the situation and restore a normal rate of profit on the investment.”

What we are getting at is the concept of “mean reversion” – that high returns will attract competition, and vice versa, until the point is reached in a given industry are on average earning their cost of capital. However, this does not occur overnight and requires investors take a long term view. Unfortunately, private investors are prone to following the latest fad...and professional managers are often driven by short term performance measurements such as their recent results versus an index.

There are also a host of psychological factors that affect all of us which diminish investors from taking contrary positions with distant payoffs. Psychological tendencies come into play to explain investor irrationality which are well-known in behavioral finance. The disappointment produced by investing in growth stocks (“those trading at high multiples or sales and earnings”) can be assigned to over-confidence, optimism and wishful thinking. In addition, failures in cognitive reasoning are common such as an investors tendency to extrapolate from small amounts of data (“law of small numbers”), to seek out information which reinforces their opinions (“confirmation bias”), to be excessively influenced by recent events (“availability bias”) and to look for patterns that do not exist (“representativeness”).

There are practical lessons to be learned.

• As you consider your next investment, remember that profitability is primarily determined by the competitive environment or supply side rather than by growth trends. Historically, it has been better to invest in a mature industry where competition is declining than in a growing industry where competition is expanding.

• The best investors are those who make fewer mistakes. Applying these concepts to your analysis does not guarantee success but by identifying over-valued sectors, you can avoid significant (and performance destroying) errors.

• Do not focus on short-term earnings or macro issues such as the broad economic indicators (unemployment, gross domestic product and budget or trade deficits)...nor the outcome of elections, the direction of interest rates or real estate prices. Rather, direct your research efforts to better understand the underlying business factors which determine investment returns over the long term.