Market Rationality and the Digital Age

In an era when a tweet can send a stock price racing, human judgment and nuance are all the more important in putting together an equity portfolio.

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With so much information available to investors today, you might think that markets have become more rational. Think again. Equity markets are as emotionally charged as ever — maybe even more so. In a short-tempered world, we believe patience and human judgment are more important than ever.

Equity investors today face an unprecedented flood of information. News wires pump out thousands of headlines, while millions of tweets and other social media posts add to the din.

Yet the deluge of data hasn’t made markets more efficient. Our research shows that U.S. stocks have been reacting more sharply to earnings surprises since 2000 than they did in the previous 13 years (see chart 1). Even with high frequency trading machines working frantically to capture every possible opportunity by the millisecond, behavioral biases have intensified. And dislocations caused by reactions to unexpected market news often last for months — just as they did in the past.

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Is there a way to overcome the information overload? A classic value investing approach is well suited to exploiting the short attention span of the digital age. In an effort to identify stocks whose recovery potential is being overlooked, value investors look for companies that have been hit by an overreaction to bad news. It’s a discipline that relies on research to cut through the information fog to focus on fundamental drivers of earnings and returns.

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Every controversy will vary according to a company’s specific circumstances, industry dynamics and surrounding events. Yet there are some common scenarios that have not really changed much over time. We frame the mission of a value investor with three simple questions:

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Will earnings recover? This question is especially common in asset-intensive cyclical industries. In a successful industry, companies tend to build too many factories or open too many stores or spend too much capital, which can lead to overcapacity. Eventually, demand usually catches up. When the industry news is downbeat, it can be very hard to determine which companies are best positioned for a rebound.

Restructuring stories create a similar dilemma. When management launches a new strategy — involving cost cuts, plant shutdowns or asset sales — markets are often skeptical and tend not to believe that the restructuring plan will work. Investors who defy pessimistic headlines to identify successful turnaround stories are usually rewarded handsomely.

Can earnings be sustained? Technological or regulatory disruption also generates controversy. Equity markets are littered with the carcasses of companies that failed to adapt to evolving circumstances — like Eastman Kodak Co. or Pan American World Airways. Yet because these failures are so dramatic, investors often project their worst fears on companies that are capable of adapting. And companies that manage to sustain earnings and thrive in a rapidly changing world tend to deliver outsize returns.

Sometimes an industry challenge or competitive threat can jeopardize an established business model — and obscure a long-term opportunity. In other cases, the mispricing of a company’s assets, whether physical or intangible, may create pressure to adapt and raise questions about the sustainability of earnings.

Is management able to fix the problem? Financial stress is another key controversy. When a company has taken on too much debt, anxious investors may push the shares down. Value investors’ keen focus on cash flows helps them determine whether management is up to the job of restructuring a balance sheet and steering a course back to success. Abundant cash flows also raise questions about management. Investors must assess whether free cash flows will be applied properly to determine whether shareholders are likely to be rewarded for their fortitude.

These three questions have one thing in common: They all require research insight and human judgment to be answered with clarity in a world of abundant information. Finding cheap investment candidates with significant recovery potential requires experience, historical perspective and the patience to look at a company in controversy and develop a conviction that a different future is possible.

Kevin Simms is chief investment officer of global and international value equities, and Joseph G. Paul is chief investment officer of U.S. value equities, both at AllianceBernstein in New York.

See AllianceBernstein’s disclaimer.

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