A couple of weeks ago Russ Fuller came to talk at a Chartered Financial Analysts of Los Angeles (CFALA) luncheon. Russ Fuller is the president of Fuller & Thaler. His company runs a couple of behavioral finance mutual funds for JP Morgan. The funds have had a good deal of success using behavioral finance techniques to choose stocks.
Usually people use one or three methods to choose a stock. They use quantitative analysis to look at the numbers, qualitative analysis to look at the business, or technical analysis to look at the past stock prices. Behavioral analysis is a fourth way. It attempts to take advantage of people’s prejudices and behaviors to make a buck. This is what Russ Fuller talked about.
Russ explained that analysts who follow stocks have built in behavioral biases, specifically the anchoring that I talked about last week. Here is how he explained it. Analysts estimate a company will make $1.00 a share. Instead their earnings come out at $2.00. If that $2.00 is a real ongoing number, the stock price should double or nearly so. However, analysts have a tendency to ‘anchor’ on their own analysis and maybe they raise their forward estimates to $1.40. Kind of dumb if the company is making $2.00 and it appears it will continue. But they are anchored on their own $1.00 estimate. They give that up reluctantly. And now there is an opportunity. If analysts are only estimating $1.40 a share for a company that is making $2.00, it will be undervalued. Over time as the analysts come to their senses, and assuming the company does deliver the earnings, the stock should rise. Buy it before they do, and make a nice profit.
Notice that this is truly different. This is not making a judgment about relative price earnings rations, nor about the quality of management at the the company and their business plan. This is just an attempt to exploit the anchoring behavior of analysts following the stock.
Russ’ funds have outperformed the S&P 500 over the last few years by a nice margin, so it appears to be working. Interesting stuff.