Analysts cling to their opinions even after new information shows they are wrong!
From Smart Money
FUND INSIGHT
Doctor, My Brother Has a Problem With His Stock
November 23, 1998
PSYCHED OUT WHO KNOWS what earnings estimates lurk in the heart of Abby Joseph Cohen? Russell Fuller knows. At least he thinks he does.
As a student of psychology, Fuller has plenty of theories on why investors and analysts behave the way they do. Now, as the manager of the 11-month-old Undiscovered Managers Behavioral Growth Fund (Sorry, no snapshot available), he is putting those theories to the test.
Fuller's premise should come as no surprise to anyone who has had even a passing acquaintance with Wall Street -- that investors and the analysts who often guide them are irrational creatures, ruled by their emotions and deeper, unconscious forces. And he's not just talking about fear and greed.
For investors, that means they may buy or sell a stock too early -- or too late. But for analysts, says Fuller, the consequences are even more insidious. Fuller believes analysts often change -- or fail to change -- their earnings estimates based on their own preconceived notions and not on a company's fundamentals. "After analysts make estimates, they sometimes get new information on a stock and ignore it because they're so confident of their original projection," says Fuller. "They don't raise or lower the estimate enough."
Psychologists call the phenomenon "cognitive dissonance." It's what happens when you get information that what you believe to be true is false, but you don't want to believe it. So you "develop contorted arguments to maintain the belief or assumptions," says Robert Shiller, a professor of behavioral economics at Yale University.
Sound like any analysts you know? It should. Members of the profession are notorious for not lowering or raising earnings estimates enough based on new information about a company.
And therein lies the opportunity for Fuller. So how does he put his theories into practice? "What we look for is a stock that has had a positive earnings surprise which is of a permanent nature, but the analyst hasn't caught on yet because he's anchored to his position," Fuller says.
So far the technique appears to be working well enough. Although Behavioral Growth Fund was only started last December, year-to-date it's up 12.2%, compared to a minuscule 0.9% for the average mid-cap fund. (Morningstar categorizes the fund as mid-cap growth.)
Fuller tries to approach the market with a blind, "unbiased" eye. He has no list of favorite stocks where he expects a surprise. Why? "Because we're human, too," he says. "If we had a prepared list, we'd be anchored to it." Instead, he waits for the surprise, then looks for the analysts' reactions on First Call and reads their earlier reports on the stock. If he thinks the analysts are biased and have underestimated the significance of the change, he buys on the day of the surprise.
For example, in the first quarter of this year, QLogic (QLGC) reported an earnings surprise of nine cents above analysts' 43-cent estimates. "Why was there a sudden change of earnings?" Fuller asked. "Because QLogic's fiber channel -- a new interface for computer servers -- became a much larger part of earnings than analysts projected." But after the earnings announcement, analysts didn't fully acknowledge this fundamental change in QLogic's source of revenue.
Fuller bought the stock the day of the announcement at $55 a share. During its second fiscal quarter, the stock beat estimates by 14 cents. Today it sells for 117 and is up 294% this year. The same approach worked with electronics retailer Best Buy (BBY), which restructured its inventory and merchandising system last year. The dissonance must have been deafening because analysts' estimates continued to miss the mark. Year-to-date the stock is up 162%.
When does Fuller sell? When the analysts catch on. "We're trying to exploit behavioral biases," he says. "When the biases are gone, the stock is fully priced. Eventually an analyst, if he's doing his job, will readjust his estimates to account for the change in the stock. Once there are no more earnings surprises, we start selling."
But sometimes, even when an earnings surprise happens, investor sentiment just isn't there. Anyone investing in small caps for the past few years knows this scenario. Fuller's investments in Avid Technology (AVID) and Keane (KEA) hit some rough spots this year, even though they have consistently beaten analysts' estimates. Both stocks are down more than 12%.
Perhaps that only goes to show that even when you think you've got the market figured, it has a funny way of psyching you out.
-- By Lewis Braham
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