Bobby Axe vs the Robots, Part 2: The Psychology of Investor Psychology
The analyst didn’t know what to tell Bobby. Two weeks ago, they had piled into Nike because they were sure the company would beat the estimates on sneaker sales in its earnings announcement.
Now two weeks from the big day, some of the big Wall Street analysts had upgraded their expectations for Nike’s results. Were they finally incorporating the credit card data Bobby was using? The stock had moved up 3% since they bought, but there was still room to run. He had calculated for a 7% beat, which would see the stock soar, but now the margin for error was smaller...
Last week, I went deep into hedge fund’s process and how it’s more like a recipe full of “secret ingredients.” But the fun stuff of what I learned from interviewing 100+ investors was the psychological kung fu involved, like I described above.
And if you think what I wrote above is hard, now try it for 20 stocks in a two week span. With leverage. Add some options too. Funds will do that to turn a 3% return into a 6% return, keep some of the profits, use the rest to make an even crazier bet, and then sell on the announcement - even if they were right - because they know others are now buying.
Aggressive investors start positioning themselves a month before earnings, before the sell-side even finishes their adjustments, according to our research. That means you need to play way ahead to have a chance, because the fast money is in charge.
Lesson learned: Don’t try to trade earnings. It’s like playing poker against pros. You’ll get your money taken from you.
But I figured only a few funds trade earnings, right? What about the rest of the year?
Well, that’s one of the dirty secrets, an investor admitted to me. Even long term funds act like “closet momentum” at times. Time is your number one constraint in a fast moving market, so even if you don’t play earnings you have to invest in hot names that can beat expectations like Nike above. Swallow your pride and ignore the fundamentals, then hold on for dear life as a more aggressive fund comes in.
Here’s Zoom in the second half of 2020 - going from $220 to $300 ahead of Q2 earnings, then taking off even more as momentum chasers pile in after. It doubles from $300 to $600 - until almost exactly a month before Q3 earnings, when it starts to falter.
My second lesson learned: In the short term, good gets better and bad gets worse - often to “irrational” levels as aggressive investors make bets on momentum. I think it’s actually the most mistake “advanced” investors make - doubling down on a bad pick, because “reversion to the mean.
The Law of Small Numbers
The analyst pointed at himself in the mirror. The auto parts manufacturer had announced buybacks and launched new products, but was still down 30% due to oil prices that should barely affect the bottom line. What to tell Bobby? “You are a rational investor!” he shouted.
“It’s priced in” are the most banal words in investing. But to make money you have to find things that are not priced in, which means you have to look at small details.
Investors will typically say to me, “I’m looking for when the second derivative changes.”
Unfortunately, companies’ financials rarely look like polynomial graphs from calculus class. They usually look more like this (growth rates for Crocs, quarterly):
What you end up with is investors staring at blips and bloops trying to determine a trend. Post Malone doing foam shoe collabs is an oddity, or at least until it turns out to be one of the hottest stocks of the year.
You’re not saying anything new. It’s hard to beat the market, no one has perfect foresight, blah blah!
That’s the thing - it’s not about lack of foresight. Rather, it’s that staring at blips and looking for trends that causes pro investors to lose - even if they’re right. Sheridan Titman, the academic who “discovered” momentum trading, believes that momentum (stocks going too high or too low) comes from rational but “overconfident” investors.
Let’s imagine investors collectively are betting aggressively on ten trends to change the future in ten years. We don’t have to imagine actually - Cathie Wood has made massive bets on self-driving, gene therapy, fintech, crypto, and space for some examples.
Now let’s say you’re the perfectly rational investor and you invest in the five trends that actually turn out right. Will you beat the market?
Possibly not! Because all five “wrong” trends are also highly valued right now, and in ten years a different five might be overvalued - but also part of the market return. Overconfidence will always be with us. In my experience from talking to funds, that overconfidence comes from three causes:
Overconfidence in interpreting data
Coming back to an earnings example: companies (via their IR functions) will hint at results that are 5-6% below what the actual results will be. That means the company needs to beat expectations by 7-8% to be a “real beat.” But companies can’t talk to investors for six weeks or so before results, and two analysts might change their estimate but two others don’t. Most of these situations are basically trying to infer what other investors are looking at based on prices.
Overconfidence in timing: Randomly Rational
Now how do you find and investigate those blips? Most funds I speak to will admit their watchlists are 200 or even 400 stocks, built up over years. You pick your next “idea” out of a garage full of old stuff.
After that, it takes a week to deep dive on a stock. Your timing depends on a good process - but also depends on your meetings running over, and when you got back from the Bahamas.
My lesson learned: Be careful about sourcing ideas from the news. You can google headlines for “Crocs are back” for the entire two year period from 2020 (when the stock had already 5x’d) to 2021 (when the stock still ran another 50%). But when you notice the headline is probably random.
Overconfidence in the organization: Conway’s law
Stiff orgs. That said, the big boys, the trillion dollar investors and the fast money, are pretty structured in how they get ideas because each analyst focuses on one industry.
But that’s not how most funds work. I usually find the same setup: one analyst for tech, one for healthcare, one for industrials, and then plug every other sector with whoever has bandwidth. Is it a surprise that hedge funds are all concentrated in tech and healthcare?
Startups all know Conway’s law: an app reflects the company that built it. Bobby Axe has the same constraints, putting his analysts to work where it seems best. Shifting those analysts around is hard and time consuming. How long will it take for the big hedge funds to retrain all their payments analysts after every fintech stock fell by 50%?
Career risk of a ten year thesis. On the other hand, there’s risk to avoiding the hot sectors too. You develop a thesis that everyone moving to Texas is going to get pools and so you buy pool supplies stocks. After a year, the stock has done nothing.
If a tree falls in the woods and no one’s around to hear it, how many years until someone finds the stump? Your boss will only take 3 or 4 of these ideas in a year, so you can only get “out there” so often.
My lesson: Owning only ten stocks means you’ll exclude a lot of the random stuff that happens - like a bankrupt company buying thousands of Teslas and driving the price up 35%. The index aggregates that randomness. I basically took this as a signal to buy SPY, as well XLK (tech ETF) and XLV (healthcare) - and hopefully benefit from funds concentration.
Are We Beating Up on the Obvious?
Maybe we’re being hard on Bobby. No other job can’t be judged as easily - the rest of us don’t compete against a benchmark in our day job.
Or do we?
The reality is all of us compete against the market everyday. When we have a new idea at work, the same dynamics apply: if it’s such an amazing idea, why aren’t the competitors doing it?
And if everyone else is doing it, are we stupid not to?
Your odds of success probably average out to 50% - because if they were better, someone else would’ve done it. The market for every business bids up the good ideas and makes the bad ideas look easy.
Maybe hedge funds can teach us something after all. Even coming close to the index in a market where most stocks go to zero in twenty years is impressive. Some of that might be because investing automatically takes in some of Philip Tetlock’s lessons on good forecasting: frequent updating (by revisiting your decisions every quarter) and changing your thinking in small gradations (by buying and selling slowly).
Diving deep into Tetlock’s work actually led me to the coolest stuff I found about forecasting: research on the wisdom of crowds. That actually led me back to a college friends - Professor Ville Satopaa, who is now one of the leading researchers on why crowds can beat experts. His research shows some interesting points:
Averages (like prices in markets!) work because they combine everyone’s information
Averages are good, but weighted averages are even better - by taking out the groupthink, and trying to distill what’s based on good insight versus guessing, you can make a good estimate better.
That seems meaningful to me, especially in the of COVID: we should listen to experts carefully, but listen even more carefully for experts deviating from the average.
Final Words
I don’t know if there’s a way to beat the index, but maybe it’s not all bad news. Some thoughts on how funds could do better:
Use a consistent weighting system. Having a process or checklist is not enough in my opinion. You also should have a research-based way to weight each piece of data in an investing decision.
Systematic ideas. Every fund should be using quantitative and factor based screening, unless they are investing in lots of names. Otherwise, it’s just coaches on the sidelines.
Better numbers - standard numbers are GIGO. Ironically, this applies to both old school and new school investors. Old school wants to only trade on fundamentals, while the new school relies too much on standard numbers without adjustments. The reality is no matter how accounting standards change etc, people are too smart nowadays not to game the system, so you need financial experts involved.
Bobby’s recipe may not be perfect, but using the same lessons could make us all better at our day jobs - maybe the difference between middle management and a billion dollar exit. Or you could just meme and troll your way there!
I’ll be back next with a post on crypto markets.