While markets are expected to behave efficiently over longer time frames, anomalies can appear in shorter spans. These anomalies are often attributed to human behavior. Mutual fund managers Russell Fuller and David Potter of Fuller and Thaler Asset Management, apply those behavioral finance principles to the Undiscovered Managers Behavior Value Fund, which concentrates on small company stocks. Behavioral finance seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions. Many of us know the adage of “buy low and sell high,” but in practicality many investors cannot implement this strategy because of their emotions. The textbook process of buying low is contrarian to the emotions of most investors.
David Potter, CFA®, lead portfolio manager with Undiscovered Managers Behavioral Value Fund says, “Often times it’s behavior that runs these markets”. From our analysis, questioning and study of past investment performance of the Undiscovered Managers Behavior Value Fund, we feel confident that Potter and the investment strategy provides the opportunity for strong performance. Unless, of course, we think human behavior will become completely rational at all times. Fragasso Financial Advisors investment research often begins and ends with performance and the quantitative factors that coincide with it. While the reasons for selecting or not selecting an investment are evident through readily available performance information, qualitative analysis involves some subjective reasoning and additional analysis beyond that found within reports. Often, the pinnacle of our research involves an interview of key personnel and team members of the strategy being analyzed. Fragasso Financial Advisors is fortunate enough to have access to many of the top investment professionals providing a level of analysis not typically found with all investment advisory firms.
In discussing the investment strategy with Potter, we were immediately able to discern the three- step investment process. Typically in the first step, Potter looks for significant insider buying or increasing share buybacks. Specifically, those share purchases are occurring during periods of “conditioning,” and thus the second stage of the investment process. At this point, investors’ pessimism is increasing and the stock is out of favor with the general market.
This second stage of the investment process has been formulated and instituted by Fuller and Thaler board member and 2002 Nobel Memorial Prize winner in Economic Sciences, Daniel Kahneman, Ph.D. Management principal and company founder Richard Thaler, Ph.D., then took those principles and refined them into the investment thesis behind the small value fund strategy. (Thaler is also the co-author of the book Nudge.) During this second stage, investors may extrapolate falling share prices and tend to over-react and become excessively pessimistic, providing an opportunity for those willing investors to “block out the noise.”
While a contrarian like Potter may believe that insiders are purchasing because they see value during times when a stock has pulled back or dropped in value, it does not alone signal a buy at this point. There is still the third investment stage, which is the fundamental credit analysis of the firm under scrutiny. There may be a very good reason why the company stock has been neglected by the market or if insiders are merely foolish in their own buybacks. Only after passing the examination of all three tests can a security be considered for their small company value fund. Small company stock managers often employ various levels of analysis including fundamental research, studying company insider purchases, as well as macro-economic theories in their investment philosophy. Using behavioral finance as an investment philosophy is more limited among investment managers.
With this three level approach grounded in behavioral finance, Undiscovered Managers has positioned themselves in a unique group of investment managers, a bit different than many others who rely on basic security analysis, offering a possible compliment to many other strategies. Replication of the process is difficult at best for most, offering a level of explanation behind their results. Our brief analysis begins to explain their approach and what is viewed as a competitive advantage we feel can continue moving forward to the benefit of shareholders and ultimately our respective clients. Although we must acknowledge that no strategy assures success or protects against loss and past performance does not guarantee future returns, our questioning provides us the reassurance that the past performance is not from randomness but rather the discipline to buy at the contrarian point.
Daniel Dingus is president and director of portfolio management at Fragasso Financial Advisors, a Pittsburgh-based investment and financial planning firm. Due to industry regulations, comments are not permitted on this blog. If you would like to contact the author, please email us at firstname.lastname@example.org. Daniel can also be reached for comment at 412-227-3200.
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