Most investors get hurt from time to time by their own big mistakes, often driven by self-defeating emotions rather than analysis. Fund manager Raife Giovinazzo, PhD, CFA, benefits by spotting investment opportunities among those mistakes made by other investors—and you can, too.
Example of how investors hurt themselves: Last December, when the stock market plunged, many investors panicked and sold, then failed to get back in as stocks rallied in the new year. Emotional decisions like that are why investors overall earned annualized returns of just 5.3% over the past two decades versus 7.2% for the S&P 500 stock index.
To benefit from investor mistakes, Giovinazzo puts into action the principles of his colleague—and PhD adviser—Professor Richard Thaler, who won the 2017 Nobel Prize for Economics. He is hailed as the father of behavioral finance, which applies psychological insights to explain why our brains seem hardwired to make wrong investment moves.
Here’s how you can use those principles to find attractive stocks…
Favor Rational Analysis
Long-term investors are most successful when they base their decisions on hard, rational analysis rather than psychological biases such as the desire to feel good or smart or even to be entertained by financial commentators on TV. To that end, I try to inoculate myself from making irrational mistakes.
I never watch channels such as CNBC for investment ideas because the financial media’s goal is to make the stock market as vivid, sexy and urgent as possible. I also avoid reading interviews or profiles with celebrity or “visionary” CEOs. Their charisma can cloud your judgment and make you fall in love with their companies. Better to let actions speak louder than words—are executives buying their own stock…and are they delivering profits?
I concentrate on small and mid-sized companies because they provide more opportunities to benefit from behavioral analysis. There is a lot less information and professional analysis of these companies versus large ones, which means that many investors tend to rely on their feelings and instincts in assessing them as investments. These investors wind up making more frequent mistakes, such as the ones described below. Instead of falling victim to these mistakes yourself, take advantage of them. I screen small- and mid-cap stocks specifically for moments when it looks like investors are acting irrationally. That’s when the best buying opportunities present themselves.
The two major types of mistakes that I focus on…
• Stocks where investors are overreacting to bad news. There are two psychological behaviors that kick in when bad news hits a company…
Loss aversion, the fear of losing money, even just on paper, which leads investors to abandon a stock at the worst possible time.
Availability bias, the tendency to make decisions based on information and events that are most recent, most memorable, personally observed and/or traumatic, rather than considering the complete picture.
The clue that investors may be getting emotionally caught up and overreacting is a stock’s share price falling at the same time that insiders—such as the CEO, CFO and/or other executives—are buying shares, either with their own money or on behalf of the company through stock buybacks. Such insiders typically have the best understanding of a company’s inner workings and long-term prospects. They know whether a company’s poor performance is not as dire as the market believes, so they aren’t so likely to panic over losses. Example: In the second half of 2018, when many small banks suffered stock price drops, insiders at those banks swooped in to buy shares at bargain prices.
It’s generally legal for corporate insiders to buy stocks as long as they notify the SEC of their trades within two business days and their purchases are not based on specific information unavailable to the general public.
Editor’s note: You can find recent insider activity for specific stocks free at the investment research firm website InsiderInsights.com.
• Stocks where investors are underreacting to good news. If a company becomes significantly more profitable, you would think it would attract investors and its stock price would rise. But that’s often not the case. One reason is what behavioral finance calls anchoring. When investors have a strong, preconceived notion about a stock and new information is introduced, they tend to be slow to change their expectations. I look for underreaction when the company announces a big quarterly earnings surprise, which means it performed much better than a consensus of Wall Street analysts tracking the company thought it would.
Most important: I use events such as insider buying and earnings surprises just as initial screens. Before I actually invest in a stock, I dig into the fundamentals of the business to make sure that its balance sheet and future prospects are strong. I like to see strong positive cash flow, especially relative to the company’s debt levels…a high return on investment…and a powerful position in a market niche.
Editor’s note: To gather data on fundamentals for a stock, check investment research firm website Morningstar.com.
5 Stocks Where You Can Benefit from Mistakes
These three companies are attractive now because investors have overreacted to bad news…
• Designer Brands (DBI). The discount shoe retailer operates more than 500 DSW and other stores in 44 states. Its stock had 4.4% annualized losses over the past five years and a 26% loss in the fourth quarter of 2018 (versus a 13.5% loss for the S&P 500). Investors who watched Amazon.com and other online retailers push shoe outlets such as Nine West, Payless ShoeSources and The Walking Company into bankruptcy proceedings feared that DSW was next. My fund initially bought DSW in 2017 after the company bought back shares. Recently, DSW has continued to defy the retail apocalypse—in part by allowing returns of online sales to its retail stores—and has surprised analysts by growing revenue at double-digit rates. In the coming months, DSW will benefit from the closing of competitor Payless ShoeSource’s more than 2,000 US stores. Recent share price: $23.09.
• Hancock Whitney Corp. (HWC). The stock of this regional bank plunged 27% in the fourth quarter even though it met analyst earnings estimates. Investors dumped many small-bank stocks late last year, worried about a slowdown in the overall economy. But Hancock Whitney, which is more than a century old and operates nearly 200 branches in the South from Florida to Texas, has a conservative lending history (it did fine during the financial crisis a decade ago). Also, it has only started to penetrate fast-growing markets such as Tampa. Recent insider buying has led my fund to add to its investment. Recent share price: $43.34.
• Ruth’s Hospitality Group (RUTH) operates or franchises 160 fine-dining restaurants around the world under the name Ruth’s Chris Steak House, where a T-bone dinner and drinks easily can cost more than $100 per person. My fund started investing in it a few years ago, attracted by heavy share buybacks. Investors have been worried that US restaurant profits will be hurt because of a possible slowdown in consumer spending—one reason the stock fell 28% in the fourth quarter. But the general restaurant-industry concerns don’t really apply to Ruth’s timeless, high-end offerings and wealthy, loyal customers. Recent share price: $25.26.
These two companies are attractive because investors have underreacted to good news…
• FTI Consulting (FCN) provides consulting on complex legal and economic issues for corporate clients. In today’s world full of lawsuits and regulations, it has been growing surprisingly fast. FTI has had six quarters of double-digit earnings surprises, with earnings 51% higher than expected in a recent quarter. Recent share price: $80.52.
Landstar System (LSTR) has a history of positive earnings surprises, but investors have not yet picked up on its full potential because they misunderstand the business model. The company operates in the trucking industry but owns only a fraction of its trucks. Instead, it is a logistical middleman connecting a vast network of shippers that need to move their goods with truck owners. I call Landstar the Uber of the trucking industry because it has a similar “asset-light” business model. Instead of needing large amounts of money to buy and maintain physical assets such as factories or equipment or a large fleet of vehicles, asset-light companies can grow very quickly without the need for large amounts of capital—surprising most investors. Recent share price: $111.64.