Mind games

Behavioral investors look to systematically profit from investors’ incurable irrationality. Crazy, but it seems to work.

All money managers “try to find mispriced securities,” points out Russell Fuller, a partner at Fuller & Thaler Asset Management in San Mateo, California. In his searches, however, Fuller mines not just the usual financial data but also the human psyche. Working with his partner, Richard Thaler, a professor of economics and behavioral science at the University of Chicago Graduate School of Business, Fulleruses applied psychology, seeking to identify irrational behavior by investors that has caused stocks to be undervalued or overvalued. Thaler, of course, is one of the leading theorists of behavioral finance.

The discipline has been around in one form or another since the 1970s (some would argue that it is centuries old). But ever since the technology stock bubble burst in 2000 -- underscoring how irrational the exuberance of investors can be -- behavioral investing has come into its own as a money management technique.

To be sure, behavioral investing is a long way from eclipsing modern portfolio theory, which is predicated in part on the “efficient market hypothesis” promulgated by Nobel Prizewinners Harry Markowitz and William Sharpe. The much-debated hypothesis holds that the market is efficient because share prices embody everything that investors know about stocks at any given moment.

Behavioral finance contends, by contrast, that markets can be profoundly inefficient -- and stocks grossly mispriced -- whenever investors behave irrationally, as they often do. As behaviorists look for underpriced stocks to buy and overpriced stocks to shun (or short), they can seem closely akin to value investors. But for the behaviorists, human psychology, not underlying corporate worth, is the starting point.

“The efficient market theory told us it’s impossible to beat the market,” says Woody Dorsey, president of Market Semiotics, a research firm based in Castleton, Vermont, that uses behavioral methods to forecast markets for about 80 institutional clients -- primarily, large hedge funds. “Behavioral finance says you can.”

The strategy’s credibility with invest-ors got a major boost in 2002, when Princeton University psychology professor Daniel Kahneman was awarded the Nobel Prize in economics for his research in integrating psychology and economics. To vastly oversimplify, his seminal work asserts that all-too-human investors -- in contrast to the coolly rational “economic man” posited by neo- classical economists -- fear losses more than they covet gains, base their actions on the way choices are presented and see their economic well-being not in absolute terms but in relation to others’.

A key tenet of Kahneman’s theory bears directly on securities markets: The “endowment effect” hypothesizes that people assign too high a value to things they already own, such as stocks.

One of the biggest behavioral invest-ors is Chicago-based LSV Asset Management, whose assets have soared, from $9.6 billion at the end of 2002 to $38 billion at the end of April, on the strength of impressive performance. Its $571 million LSV Value Equity Fundreturned 11.54 percent annually, on average, for the five years ended May 20, handily outperforming the Standard & Poor’s 500 stock index, which lost an annualized 1.8 percent.

“We focus on buying cheap stocks that are unpopular because the majority of investors have biases that make these stocks less appealing to them,” says LSV’s CEO, Josef Lakonishok, who along with two other academics founded the firm in 1994. “Investors often tend to extrapolate historical growth rates too far out into the future,” Lakonishok explains.

Fuller & Thaler, with $3.2 billion in assets, acts as a subadviser to the $102 million Undiscovered Managers Behavioral Value Fund and the $127 million Undiscovered Managers Behavioral Growth Fund, both of which J.P. Morgan Chase & Co. acquired last year. The value fund’s long-term record is persuasive: For the five years ended May 20, it returned an average annual 13.07 percent -- beating the S&P 500 by almost 15 percentage points a year, on average.

President and CIO Fuller focuses on finding stocks that are mispriced because of such behavioral biases as “representativeness” -- the tendency to stereotype companies and cleave to negative perceptions even in the face of positive news.

To exploit this predisposition, Fuller seeks out underperforming stocks of companies that are signaling through insider buying or share repurchasing that a fundamental improvement is under way.

“It’s important that the stocks have underperformed, because we want market participants to be biased forecasters,” he says. Fuller uses fundamental research to identify the reasons for insiders’ purchases. “The market is very noisy, and there are all sorts of reasons why insiders may be buying stocks that do not indicate a positive change,” he explains.

“The key for us is to identify the underlying fundamental change,” Fuller says. Fuller started buying Blue Coat Systems, a provider of Web content security solutions, last September, at about $11 a share. The stock had plunged from a March high of $60. After researching the company, Fuller learned that Blue Coat was preparing to release an upgrade of its principal product, ProxySG, about which management was very optimistic. It proved a success, and Blue Coat’s earnings began to improve.

Fuller sold the fund’s position in the stock in the first quarter, after it rebounded to $24.

In running J.P. Morgan’s Undiscovered growth fund, portfolio manager Fred Stanske seeks to capitalize on securities analysts’ tendency to hold fast to their earnings estimates in the face of new data that should alter their analyses. He screens for companies that have reported better-than-expected earnings, say, then carefully examines their financials to be sure that the surprise stems from a lasting change.

In late November 2003, Stanske snapped up shares of Autodesk, a software company providing computer-aided design software and multimedia tools, at $11.18 a share. The company had reported third-quarter earnings that were 43 percent higher than the consensus forecast, reflecting strong sales in its recently upgraded flagship product, Auto- CAD, a PC-based drafting system used primarily by architects and engineers. Although most analysts assumed the upturn was temporary and remained irrationally attached to their forecasts, Stanske says, he concluded that the growth would persist and invested 1.5 percent of the fund’s assets in the stock.

“The company was upgrading its licensing agreements, its new AutoCAD product was proving successful, and operating margins were expanding,” he explains. Autodesk was trading at $32 in mid-May. Stanke’s position in it has grown to 2.5 percent of assets, even though he has trimmed the stake.

Well-known contrarian investor David Dreman, chairman of Dreman Value Management in Jersey City, New Jersey, which manages $12.5 billion, likewise looks for analysts to overreact to news, good or bad. The record of his $6.2 billion Scudder-Dreman High Return Equity Fund -- an average annualized 14 percent over the past decade -- suggests he’s on to something. “Our research shows that analysts’ forecasts can quickly change from overly optimistic to overly pessimistic,” says Dreman.

Case in point: Best Buy. Dreman took a substantial position in the stock in November 2002, shortly after the company announced lower-than-expected earnings. The stock had plunged, from $48 in May to $18. After scrutinizing the company’s sales growth and profit margins, Dreman determined that Best Buy was still growing earnings at an above-average rate. But the retailer had the same price-earnings multiple -- between 10 and 11 -- as department stores with half its growth, he notes. In the succeeding 11 months, the stock climbed back to $54 a share.

Margaret Stumpp, chief investment officer for Quantitative Management Associates, a subsidiary of Prudential Financial, uses a behavioral finance model to pick stocks for the $199 million Dryden Large-Cap Core Equity Fund, an enhanced index fund that she comanages. The fund is up an annualized 5.6 percent for the three years ended May 26, surpassing the S&P 500 by 36 basis points a year.

As Stumpp sees it, investors undervalue the yield component of the total return of slow-growing stocks. Therefore, in evaluating such stocks, her model places the most weight on core valuations. By contrast, in the case of fastgrowing companies, she explains, “in- vestors tend to be anchored in their old views and are slow to respond to new, contradictory information.” Therefore, for those companies the model places more emphasis on news developments.

Last year Stumpp scored a hit with Charlotte, North Carolinabased Nucor, the largest, and one of the lowest-cost, steel producers in the U.S. She categorized Nucor as a slow-growing company and, at the start of 2004, bought the stock at a split-adjusted $30. “No one expected steel companies to do well last year,” she says. But as the dollar weakened, making imported steel more expensive, domestic producers gained. Nucor rallied 89 percent last year. When the stock climbed to nearly $55 in February, Stumpp trimmed her position. Nucor recently traded at $53.