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Biases, Biases Everywhere

Tyler Durden's picture




 

Look around the investing world and biases are pervasive, from clustering estimates around company guidance (anchoring) to avoiding a stock that has already outperformed (mental accounts). And these biases make a difference.

Via Goldman Sachs,

Biases creep into the investment process at two important stages.

First, when forming estimates. The starting point (baseline) is key, and rather than using industry dynamics (an outside view), estimates may be influenced by company guidance (vulnerable to vested interests and dated industry dynamics given complex reporting lines), consensus estimates (themselves vulnerable to bias) or an emphasis on well-known newspaper articles. Adding detail to a scenario may make it more memorable, but the detail itself will reduce its likelihood (more is more fallacy). Data may be selected to support a pre-supposed thesis (confirmation bias) and presented as such (positive framing). And expectations may be altered by share price performance on the day of an announcement
(causal thinking).

 

Second, biases find their way into the investment decision. Even a bias-free upside calculation may be ignored and over-ridden when the share price is falling (herding with other fearful investors) or the company has been subject to a recent negative press story (recency bias, availability bias). Stocks may be held rather than sold because they’re in negative territory (loss aversion), the evidence for change doesn’t seem strong enough (status quo bias) or we think we knew it all along (hindsight bias). Low-growth segments of a business may look attractive when presented by a strong management team (halo effect) and the question ‘is the stock fairly valued’ may be interpreted as ‘do I like the stock’ when forming the investment case (substitution effect).

These biases really matter. Overcoming them and applying systematic rules can enable significant alpha creation, from creating a ‘quality control’ check on additions to a portfolio, to applying a stop-loss when stocks underperform.

From bias to error

These biases aren’t just interesting observations. They lead to estimate errors (garbage in, garbage out) and inappropriate stock recommendations. While many errors are analyst-specific, and hidden beneath the surface when aggregated within consensus, some persist from analyst to analyst and quarter to quarter. And we can measure them. We make three key observations:

Clustering at mediocrity

First, top-line variability is consistently underestimated. Consensus revenue growth forecasts will typically start in the 5%-6% range for the market at large, but the true outcome almost always turns out to be a significantly higher or lower level. While nine of the last ten years’ consensus revenue growth forecasts have been initially in the 5%-6% range, no year saw actual growth within that range. Analysts are reluctant to take a significant view on growth ahead of the date (conservatism, risk aversion), and/or are anchoring to economists who themselves are making the same mistake.

Put another way, over the last decade analysts have typically expected 50% of companies to report sales growth in a 2%-8% range, yet only 23% have actually delivered sales within this range.

Conservative in cash-use

Second, analysts will typically underestimate the extent of reinvestment via capex or M&A. Net debt used to fund this reinvestment has been revised upwards in seven of the last ten years, irrespective of the market environment. This may reflect conservatism and a lack of incentive to take a view on lumpy investment. It may also reflect anchoring to company guidance, which itself is disincentivised to announce investment plans early (take a look at the consensus 2013 and 2014 deleveraging assumption. In an environment of ageing assets and rising visibility, are companies really going to buck the trend and de-lever rather than reinvest?).

The wood from the trees

Third, analysts will frequently revise estimates post company results, but will less commonly revise estimates in the intervening period. As such, analysts will over-weight information presented by the company, but under-weight data on the broader market (GDP, inflation, unemployment) or the company’s position within it (pricing power, barriers to entry etc, potentially sourced via primary research). Analysts can miss out on the full picture, or the representative dataset, which can distort estimates.

The consequence... bifurcation underestimation...

The demonstrable biases above are probably just the tip of the iceberg. But, each one will have a meaningful impact on long-term earnings estimates, and these will discriminate from company to company. One group of stocks standing to benefit is those with profitable growth opportunities. Company managements will rarely disclose the full extent of future capex plans (conservatism, lack of incentive) and yet their commentary can be disproportionately weighted (manifestation #3 above) and as such the extent of reinvestment and releveraging will be underestimated (manifestation #2).

Who cares?

All this focus on estimates, but do they really matter? Can’t we just rely on average estimates but decent models? Unfortunately we can’t. Just as the conclusions of classical economic theory have been challenged, because the assumption of human rationality is unrealistic, so recommendations taken from inaccurate estimates (irrespective of models) can yield underperformance. To provide an example, buying Stoxx 600 companies on low P/E multiples (and selling high) would have generated c.25% annual alpha over the last decade using 12-month forward actual reported earnings, but would have lost c.3% per annum using consensus estimates. Interestingly, you would lose less money applying historical earnings (-2% alpha pa) than by using consensus estimates.

 

 

Simply put, biases make consensus estimates worthless.

 

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Sat, 02/16/2013 - 20:29 | 3250469 Squid Vicious
Squid Vicious's picture

I'm not biased, I watch CNBC all day and then make very prudent stock picks...

Sat, 02/16/2013 - 20:40 | 3250481 SilverTree
SilverTree's picture

Normalcy bias bitchez.

Sat, 02/16/2013 - 20:59 | 3250508 AlaricBalth
AlaricBalth's picture

Steve Forbes once said, "You make more money selling advice than following it. It’s one of the things we count on in the magazine business—along with the short memory of our readers.”

This axiom is the bedrock of the financial services industry.

Sun, 02/17/2013 - 02:49 | 3250890 prains
prains's picture

"Bias" is the little sister with cerebral palsy compared to corruption which is the fat bitchy sister who gives it up to anybody who pays attention.

 

The issue in the U S od A is not HOW to identify the "sisters" it's really how to manage an unfixable problem without dragging the rest of the world into WWIII

which obviously will be made to look like somebody elses fault 'cause how is the US gonna make their GDP sing again without it???????

Sat, 02/16/2013 - 21:33 | 3250563 EscapeKey
EscapeKey's picture

As if they'll ever tell you to buy a stock index.

Sun, 02/17/2013 - 09:23 | 3251071 csmith
csmith's picture

"buy a stock index."

The ONLY truly useful investment advice I've ever seen.

And preferably the CHEAPEST one possible.

Sat, 02/16/2013 - 20:34 | 3250475 tango
tango's picture

Bias could only be evaded if machines without a directed purpose were making decisions and even that's questionable due to programming.  Clients have their money involved, brokers and managers have client money involved, banks, governments, businesses - all make forecasts/decision influenced by bias.  On ZH, for example, many have refused or dropped out of market investments due to impending warnings of doom despite the Tylers assiduous following of CNBC, Goldman Sachs, JPM, chartists and other mainstream financial information.  The last part was a perfect summation- human rationality is an unrealistic base upon which to build a science.   Which is why choice is still supremely important. 

Sat, 02/16/2013 - 20:34 | 3250476 Mr Lennon Hendrix
Mr Lennon Hendrix's picture

Arthur Anderson reporting for duty!

Sat, 02/16/2013 - 20:44 | 3250489 Yen Cross
Yen Cross's picture

  Perceived Value.   The Dax, asx200, Hang Seng, kospi, ect... Are over bought. I Global GDP is declining> how can markets inflate.

    When I was a kid, a dime meant something. My mom valued dimes more than Quarters.

 

Sat, 02/16/2013 - 21:02 | 3250510 Mr Lennon Hendrix
Mr Lennon Hendrix's picture

Well thankfully El-Aryan said to take profits. 

If it wasn't for him I don't know what I would do.

Sat, 02/16/2013 - 22:09 | 3250616 FreeMktFisherMN
FreeMktFisherMN's picture

'A buck ain't worth a dime anymore'

Sat, 02/16/2013 - 21:05 | 3250515 russwinter
russwinter's picture

Here is that Walmart story from Bloomberg.   Gee, I know I may be as "confirmation biased" as anybody, but isn't ignoring all this going beyond absurd? Shouldn't be any surprises here.: 50 cents higher gas since mid-December, higher food prices, 2% payroll tax rollback and Joe Sixpack has blown his money on XMAS,  guns and ammo. 

“In case you haven’t seen a sales report these days, February MTD sales are a total disaster,” Jerry Murray, Wal- Mart’s vice president of finance and logistics, said in a Feb. 12 e-mail to other executives, referring to month-to-date sales. “The worst start to a month I have seen in my ~7 years with the company.”

Murray’s comments about February sales follow disappointing results from January, a month that Cameron Geiger, senior vice president of Wal-Mart U.S. Replenishment , said he was relieved to see end, according to a separate internal e-mail obtained by Bloomberg News.

“Have you ever had one of those weeks where your best- prepared plans weren’t good enough to accomplish everything you set out to do?” Geiger asked in a Feb. 1 e-mail to executives. “ Well , we just had one of those weeks here at Walmart U.S. Where are all the customers? And where’s their money?”

Sun, 02/17/2013 - 00:45 | 3250796 otto skorzeny
otto skorzeny's picture

commie bastards at WalMart will only let you buy 3 boxes of ammo within a 24 hour period. the only thing I see people buying in wal-mart are necessities-not many "want" items-only "need" items. of course with gas at $3.99 for the first time ever around here Walmartians are a little strapped for cash.

Sat, 02/16/2013 - 21:16 | 3250531 A Lunatic
A Lunatic's picture

Fuck you Goldman Sachs!

Sat, 02/16/2013 - 21:23 | 3250545 Being Free
Being Free's picture

the assumption of human rationality is unrealistic

"In the South Seas there is a cargo cult of people. During the war they saw airplanes land with lots of good materials, and they want the same thing to happen now. So they've arranged to imitate things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head like headphones and bars of bamboo sticking out like antennas—he's the controller—and they wait for the airplanes to land. They're doing everything right. The form is perfect. It looks exactly the way it looked before. But it doesn't work. No airplanes land. So I call these things cargo cult science, because they follow all the apparent precepts and forms of scientific investigation, but they're missing something essential, because the planes don't land." - Richard Feynman http://calteches.library.caltech.edu/51/2/CargoCult.pdf

Sat, 02/16/2013 - 21:36 | 3250565 q99x2
q99x2's picture

You can tell by the way playdough face Greenspan was talking that the IRS is going to make Enron accounting the legal standard for listed companies. Nobody will know anything. Just like with the banks.

FRAUD INDEXES all of them.

The biggest case of this recently is Obama's tax incentives for FB.

Sat, 02/16/2013 - 23:50 | 3250740 Stuck on Zero
Stuck on Zero's picture

Bias is good.  It gives contrarians an edge.

 

Sun, 02/17/2013 - 00:49 | 3250798 Yen Cross
Yen Cross's picture

 This is good. I  Re Read the charts!

Sun, 02/17/2013 - 01:07 | 3250822 billybobtx
billybobtx's picture

Trackers. trackers everywhere, thanks yet again my tyler friend.

Sun, 02/17/2013 - 09:18 | 3251067 csmith
csmith's picture

"As such, analysts will over-weight information presented by the company, but under-weight data on the broader market..."

IOW, managements can be wrong, and those analysts who are willing to recognize this and either find managements who are more consistently right or are able to game the numbers long enough to fool the market (GE 2002 -2007 ?) will do better.

Sun, 02/17/2013 - 10:12 | 3251109 hedgeless_horseman
hedgeless_horseman's picture

 

 

Biases creep into the investment process at two important stages.

Goldman did not mention their bread-and-butter, that is their clients'  "I am not the bigger fool bias."

If one is not actually envolved in trading it is all too easy to forget that there were, are, and always will be two sides to every trade.  One of the parties is usually making a mistake.

Sun, 02/17/2013 - 19:36 | 3251936 trendybull459
trendybull459's picture

its all right,you buy stocks which earnings virtually moved into sky

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