Your Industry  

Masterpiece in the making

Masterpiece in the making

Michelangelo, arguably the most renowned and influential artist, architect and poet of the High Renaissance had a famous line: “Every block of stone has a statue inside it and it is the task of the sculptor to discover it.” 

Creating life-size human forms from mundane slabs of marble is no easy task; the art is in finding the undiscovered and unanticipated buried within the medium.

Selecting investment ideas from the midst of the global equity indices is just as tough, but focusing on specific areas of unanticipated growth can help deliver higher returns.

Article continues after advert

This week, we will focus on behavioural finance and how general investor behaviour can help open up opportunities for managers to uncover that unanticipated growth. Let’s first take a look at a few behavioural finance concepts.

Investor decision-making is shaped by biases that lead to a divergence between price and fair value. The basic idea is that investors tend to be overly optimistic about growth companies (companies whose earnings are expected to grow at an above-average rate relative to the market) and overly pessimistic about value companies (companies that tend to trade at a lower price relative to its fundamentals).

These views are rooted in the human tendency to be overconfident, where individuals have rosy perceptions of their own abilities. The overconfidence effect contributes to an overpricing of traditional growth companies and causes investors to under-react to new sources of unanticipated growth.

This effect is clearly in evidence in sell-side analyst forecasts, suggesting that analysts fail to fully account for the powerful mean reversion in growth rates. This implies that earnings forecasts for fast-growing companies tend to be overoptimistic, as illustrated in the lacklustre portfolio return from holding stocks with the best ex ante growth forecasts. 

Clearly, the forecasts were fully anticipated in share prices. But there are significant returns from holding those stocks with the highest ex post realised growth. The implication is clear: analysts failed to correctly forecast the highest realised growth stocks. The real growth stocks were unanticipated.

These behavioural inefficiencies can be exploited by building a portfolio with higher price and earnings momentum and higher quality than the market to access unanticipated growth. These companies that exhibit positive earnings and share price momentum will on average deliver growth ahead of analysts’ forecasts. 

This is because overconfident investors and analysts exhibit anchoring and herding behaviours that leads to trends in earnings forecasts and share prices. Strong upward revisions to forecasts are often an indicator that a stock will outperform going forward. In addition, stocks that have performed well over the last 12 months tend to continue to perform well. Conversely, stocks that have performed poorly tend to continue to underperform.

In addition, companies with high-quality characteristics are more likely to sustain periods of unanticipated growth. “High quality” is defined as companies that are profitable, have sustainable earnings and have a management team with strong capital discipline. It can help to avoid companies whose profit growth and margins are not sustainable.