Investors who are prepared to base their choices on something more than human nature and instinct are able to cultivate a long-term edge in the quest for a sensible balance of risk and return says Tobias Bucks, co-manager of the IFSL Marlborough Global SmallCap Fund. But what has that got to do with energy drinks?
According to an academic study published just over two decades ago, how much we pay for an energy drink influences our problem-solving ability[1]. Believe it or not, this ostensibly bizarre finding has major implications for investors.
To understand why, we first need to get to grips with the research itself. To cut to the chase: volunteers were provided with energy drinks – some discounted, some at full price – and then invited to tackle a series of word puzzles.
Overall, the performance of those who consumed the cut-price drink was significantly inferior to the performance of those who consumed the full-price drink.
You might consider this perfectly reasonable. But there is, of course, a twist in the tale: the drink was the same in both instances.
As the study concluded, what we have here – broadly speaking – is evidence of the subconscious effect of expectations. It’s a phenomenon to which we’re all susceptible, even thought we may not realise it.
Basically, this boils down to a matter of inherent biases. People tend to assume an expensive product must be good and a cheap product must be bad.
We might think of this proclivity as a combination of human nature and consumer instincts.
And so we come to the wonderful world of investing. In the sphere of global equities, particularly towards the lower end of the market-capitalisation spectrum, a similar bent for prejudice and predisposition frequently runs riot.
Many investors near-instantly decide a company has to be worth backing if it’s highly valued.
Much the same knee-jerk response is likely if a business is in the midst of a conspicuous growth spurt, gets great press or ranks as a go-to pick among the analyst community.
Equally, many investors quickly arrive at the opposite view if a company’s valuation is notably modest.
They might also lose any vestige of enthusiasm at a stroke if a business is struggling to expand, has never earned a single column inch of media exposure or rarely registers on an analyst’s radar.
This helps explain why “the herd” exists, why it’s usually so vast and why those who dare to defy it are routinely regarded as obdurate troublemakers who go against the grain merely for the heck of it.
Perhaps even more importantly, it also helps explain why the herd is often mistaken – and why casting aside innate biases may be one of the most productive steps an investor can take.
Irrationality and opportunity
Our fund specialises in smaller companies. We look for high-quality businesses that are capable of delivering growth over an extended time horizon. Ideally, what we’re really looking for is unrecognised growth.
That’s a tricky task when biases rule the roost. At-a-glance appraisals and rapid-fire inferences might go some way towards identifying likely growth, but they’re seldom sufficient to spot the sort of promise that habitually escapes the herd’s collective gaze.
Our fund’s biggest holding, Mueller Industries, offers an illustration. A US business centred on piping and industrial metals, it was the subject of virtually no analyst coverage when we first explored the possibility of investing in it – and it remains largely overlooked today.
Our own screening process always begins with a wider assessment of sectors and regions before gradually zeroing in on individual companies.
We then engage directly with these businesses, as well as their suppliers, customers and other stakeholders – using a list of around 200 questions to explore five areas of value creation.
In Mueller’s case, as with any company that piques our interest, we eventually drew on a combination of quantitative and qualitative data to produce a projection of future earnings.
Finally, we checked our opinion against the general market consensus.
We were delighted to discover we were markedly at odds with the herd. Cheaply priced and essentially unfashionable – rather like a discounted energy drink, remarkably enough – Mueller had clearly generated low expectations.
We therefore figured we might have a hidden gem on our hands. At least to date, history appears to have proved us right. The company has continued to go from strength to strength ever since.
The moral of the story is eminently straightforward: equity markets are irrational. We can thank the vast majority of their participants for this amusing state of affairs.
The idea that a can of bargain-basement Red Bull rip-off somehow impairs our capacity to unscramble words is rooted in the same warped thinking that shapes countless ill-informed and potentially costly investment decisions.
This, ultimately, is how opportunities arise. Crucially, it’s also how investors who are prepared to base their choices on something more than human nature and instinct are able to cultivate a long-term edge in the quest for a sensible balance of risk and return.
[1] See, for example, Shiv, B, Carmon, Z, and Ariely, D: Placebo Effects of Marketing Actions: Consumers May Get What They Pay For, 2005 – https://www.ias.edu/sites/default/files/sss/papers/paper26.pdf.
Main image: energy drinks, emmanuel-edward-XPOKCs4Jce4-unsplash
