Exploiting investor behaviour - Why time frames matter

This year, global equity markets could be characterised as extremely choppy. Market volatility has reflected uncertainty and changing risk appetites around daily macroeconomic and geopolitical news flow. In response to this volatility, investment decisions appear to be based around increasingly shorter investment time horizons, which are ultimately unsustainable.

Sep 2018

Symptoms of short-term investor behaviour and company management’s response

Short-term investor behaviour can have a material impact on markets. A comprehensive literature review by the Centre for International Finance and Regulation (CIFR) summarises the costs of short-term investor behaviour as greater market inefficiency; excess volatility; procyclicality; less effective corporate monitoring; and less efficient intermediation due to additional costs1.

Empirical evidence suggests that short-term investor behaviour can lead to sub-optimal performance outcomes. Research by Cremers and Pareek (2015) suggests that low portfolio turnover is a significant determinant of outperformance by active managers, when it is combined with a high active share (the proportion of stocks in a portfolio that differ from those in the benchmark). The researchers found that “only the most active and patiently managed funds have on average been able to outperform… We thus find that only active bets that were also patient (i.e. longer term) were rewarded in the markets, but find no evidence that active short‐term bets were profitable2”.

Research by Mercer found a strong tendency for active long-only managers to have higher turnover than they claim, resulting in high trading costs and a risk of misalignment between the client’s and the manager’s time horizon. Managers reported experiencing pressure from clients to demonstrate short-term outperformance against a benchmark3.

Short-term investor behaviour drives market anomalies

The current market environment has been bifurcated between two extremes. Earlier in the year, when news flow was supportive of an ongoing global growth narrative, market risk preferences gravitated towards companies with high earnings growth and momentum - without consideration to valuation.

For example, in Japan, this was most pronounced in a narrow group of technology-related stocks. In Fig.1, we compare the valuation for auto stocks in Japan which have become significantly mispriced in response to shifts in shorter-term market risk preferences. On the other hand, more recently news flow has challenged the status quo for growth, and market risk preferences have swung towards more defensive companies with perceived shorter-term earnings certainty and earnings visibility - again without consideration to valuation. Valuations are now at episodically expensive levels for both these segments in Japan, which suggests the risks are to the downside. In Fig.2, we compare these “expensive Defensives” with the Financials sector which have become mispriced in response to the market’s entrenched beliefs around the permanency of the Bank of Japan’s negative interest rate policies and the extrapolated beliefs around the implications for earnings.

Fig 1. Technology v Autos sector - Price-to-Book ratio ("PBR") relative to Topix4


Fig 2. Defensive v Financials sector - Price-to-Book ratio ("PBR") relative to Topix5


Trump’s trade war is more than priced with the market extrapolating implications

No-one “wins” in a trade war, however the market has already more than priced this into valuations for the auto stocks that we have identified as part our fundamental research.

Our trend margin sensitivity tests for selected auto stocks suggest that the market is more than pricing in zero returns in trend terms from their U.S. business segments.

Whilst U.S. tariffs aimed at Japanese autos are possible, it is also plausible that Japan may not be a primary target. Since the 1980’s Japan / U.S. “car wars”, Japanese automakers have raised U.S. production tenfold while shrinking exports by half amid increasing direct investment into the U.S. and supporting more than 1.5 million U.S. jobs6.

Japanese autos have no tariff protection against U.S. auto imports to Japan and 75% of Japan’s “Big 3” auto production is now outside of Japan. For example, 84% of production for Honda is outside of Japan7.

Additionally, Japanese auto manufacturers stand to benefit from China’s auto tariff reduction from 25% to 15%. China is now the largest auto market in the world.

Furthermore, the E.U.-Japan Economic Partnership Agreement is the largest bilateral free trade agreement and will eliminate 99 percent of tariffs on Japanese imports by the E.U. This will also be a benefit for Japan’s auto exports to Europe.

Negative interest rate environment leading to price opportunities

We observe the market is now extrapolating a permanent state of Bank of Japan’s policy of low interest rates. This has been accompanied by an oversimplified rationale that Japan’s bank earnings are also permanently impaired.

The negative effects of yield curve control on net interest income are now more than priced in by the market. In fact, we now observe that these negative effects have passed through for major banks with spreads on new loans now bottoming.

The overly simplistic market rationale ignores the reality that Japanese banks have been operating in low interest rate environment for a very long time. The major banks have been adapting for many years by diversifying earnings streams away from the domestic interest rate cycle and this has been accelerating since 2008.

The major bank stocks that we have identified as part of our due diligence are well capitalised with strong balance sheet health, have high and defendable dividend yields as well as ongoing share buyback programs which are accelerating.

Major banks are now addressing their cost structure including branch and labour rationalisation, which has the potential for operating leverage. Importantly, valuations are very attractive with plenty of upside potential to compensate for the apparent risks to longer-term sustainable earnings.

Whilst the circumstances change, investor behaviour does not

Amidst this narrow market environment, where very expensive stocks are driving price momentum, a common question that has been raised by our clients and stakeholders is, “what are you doing about shorter-term performance?”

At Eastspring Investments, we believe what you choose to do or not to do in decision making are both equally important. It can mean the difference between demonstrating skill – which is repeatable – or being subject to luck – which is random and temporary.

When faced with common influences such as complexity, ambiguity, time pressures and uncertainty, decisions can become mentally and emotionally tough to manage for all individuals. To ease this mental stress, we are all subject to subconsciously reverting to our strong personal preferences to form our decisions. Our personal preferences are subject to cognitive bias, and when left unchecked, we are all prone to judgment errors.

To highlight this, and at the risk of overdosing on football with the FIFA World Cup fever behind us, we are reminded of a well-known study of professional goalkeepers and their drive to ease their own mental stress through action bias or the need “to do something”.

Investor behaviour is not unique, it’s universally observed

Imagine you are a goalkeeper in the final minute of a crucial World Cup match. You are about to face a penalty kick and the result hangs in the balance. If you save the penalty kick, your country moves into the finals. If you don’t, you are on the next flight home…

You have no idea which way the penalty taker will choose to direct the kick. You effectively make your decision simultaneously with the kicker.

Should you dive left, right, or stay where you are in the centre of the goal?

The study8 of professional goalkeepers found the following results around their behaviour:

The stakes are high… goals are scored 80% of time from penalties

  • Professional goalkeepers often choose to dive either left or right. The study found this to be the case 94% of the time. Goalkeepers display a distinct action bias.

What is the optimal strategy?

  • The goalkeeper who stays in centre saves 60% of kicks aimed at the centre.
  • This is the optimal strategy for saving goals as it is far higher than when the goalkeeper dives either left or right with only 12%-14% saved.

But the goalkeeper rarely stays in the centre at around 6% of the time.

Why don’t goalkeepers choose the optimal approach?

Goalkeepers feel like they are making more of an effort when diving left or right. Whilst a diving save may “feel right”, it is clearly the statistically sub-optimal strategy. The weight of probability strongly suggests staying in the centre is the best strategy. Despite this, when goalkeepers were asked why they chose to dive, the common response was that standing in the centre makes you “feel” much worse. Following the optimal strategy may be emotionally hard to do but is likely to pay the greatest rewards over the longer term.

Putting the weight of probability in our favour

The persistence of judgmental errors in the market can drive prices to the extremes of both expensive and cheap. This is the market behaviour we observe today, and this brings significant price opportunities that our contrarian approach can exploit.

In making skilful investment decisions, we need to identify a way to put the weight of probability in our favour. We need to mitigate the potential for errors in our judgment. We can achieve this by adopting a carefully conceived decision process that anchors our judgment. Our approach is to consistently apply a disciplined valuation approach to anchor our own judgment in exploiting opportunities driven by investor behaviour in the market.

In short,

  • Errors in investor judgment, which commonly arise from both consensus market behaviour and risk preferences, can lead to significant price swings in the market.
  • A disciplined valuation anchor enables us to mitigate potential errors in our own judgment and to avoid market following behaviour.
  • A disciplined valuation anchor enables us to fully exploit the market’s temporary risk preferences. It focuses our analytical resources toward the most mispriced opportunities that offer the greatest potential return.
  • This approach is not bound to the persistence of any consensus themes or market behaviour.
  • A discipline around price and valuation ensures that we avoid fully priced assets that result from changes in consensus-driven market behaviour.

The market’s preference for growth, whether it is represented by high earnings growth or by shorter-term earnings certainty, has led to extreme valuation anomalies that our approach can exploit.

This is evident when comparing the Price-to-Book ratio of MSCI Japan Growth with the MSCI Japan Value Indices. The differential is now exceeding the last price episode of 2016 and we are now approaching the historic extremes last observed in the Dot Com Bubble (see Fig 3).

Fig 3. MSCI Japan Growth Index Price To Book Relative To MSCI Japan Value Index Price To Book9


The weight of probabilities suggests the risks are firmly to the downside for expensively valued growth stocks. We believe this represents a buying opportunity for patient valuation-driven investors.

Time frame helps to put the probability of outcomes in our favour

We accept that it is extremely hard to be more “informed” than the market and we do not rely on forecast accuracy in our analysis. We humbly understand the limitations of our knowledge. We believe it is better to be approximately right than precisely wrong.

A patient time frame can improve the probability of outcomes. We therefore require a significant trend valuation upside to compensate us for two key risks:

1. The future is inherently uncertain, and this requires our approach to adopt a significant margin for safety in estimating the trend valuation upside.

2. Market behaviour may persist, and assets may remain out of favour for an indeterminate length of time. Significant valuation upside compensates for the time it may take for the market to realise value in an asset.

A high valuation upside offers a significant margin for safety and is an acknowledgment that our approach does not rely on forecast accuracy. A high conviction around trend fundamentals enables our approach to remain patient amid market uncertainty and to exploit shorter-term price volatility in a contrarian manner.

Dean Cashman

Portfolio Manager