One of the observations that won behavioral economist Richard Thaler a Nobel Prize is, in essence, that investors tend to keep their friends close — but their enemies closer.
That is, they habitually sell the winners in their portfolios while refusing to sell the losers. Thaler’s technical name for that habit is the “disposition effect.” But Fred Stanske, a portfolio manager at $9.3 billion Fuller & Thaler Asset Management, says the Nobel laureate has a catchier nickname for it: “Get-even-itis.”
“When someone gets a piece of positive news in a stock and it goes up, they usually have the inclination to sell that stock versus holding on for future goods news, and correspondingly, if they get bad news and the stock goes down, they continue to hold it hoping it will come back and they’ll get even,” Stanske said in an exclusive interview.
Stanske has worked at Fuller & Thaler since 1996. He runs its Behavioral Small-Cap Growth Fund, which seeks profits in Wall Street’s mistakes and biases. Small-company stocks are having a notably bad time in 2020, but Stanske’s fund has returned 21.9% to investors as of September 2, well ahead of major indexes and most small-cap growth funds.
How they find stock picks
Fuller & Thaler’s funds target stocks that are either underreacting to good news or overreacting to bad news. Stanske’s fund is in the first category. Instead of looking for stocks that are about to move higher, he wants companies that are already rising because of developments like strong earnings or new products, but have much further to go.
“We’re actually buying the news of the positive information and we’re actually selling it when the analysts or the market participants have caught up to that new at new earnings stream or that new information about the company,” he said.
The key to that is finding stocks where analysts are too slow to update their estimates and views once that good news arrives. That makes them, in the firm’s language, “biased forecasters,” and it can be a sign of opportunity in the stock. If expectations are stubbornly low, the company should beat them repeatedly, leading to long-term gains.
“The next quarter, you’re going to see a positive earnings surprise, or sales surprise. And this will go on for a number of quarters until the analysts actually catch up.”
It’s only at that time, typically after a year and a half to two years, that he’ll sell the stock.
Dealing with their own biases
While the Fuller & Thaler managers makes money based on the biases of others, they don’t pretend to be free of them either. Instead, they aim to be aware of them and take them into account, and he urges investors to do the same.
“I think the most important thing that everyone should know is that the behavioral biases are hardwired into us as human beings,” he said. “We’re all overconfident to a great degree … market participants are very overconfident in their opinions on companies.”
The firm takes some surprising steps to keep biases from creeping into their investment decisions. When Stanske or one of his colleagues adds a new stock to one of their funds, it always takes up between 2% and 2.5% of the portfolio. They don’t buy more than that, or less, based on their confidence and expectations for that investment.
“We could make that decision wrong just like everyone else does at one point in time or the other,” he said. That also reduces the likelihood they will fall pray to “get-even-itis” and hang on to a bigger investment that hasn’t worked out.
Since every investment starts at roughly the same size, the largest positions in the portfolio are just the investments that have been most successful. Today, those are telemedicine company Livongo, biotech company Sarepta, and cloud computing services firm Fastly.
Based on the idea that they can be wrong just like anyone else, they don’t have industry-specific analysts and don’t make precise estimates for company performance.
“We don’t build models because we don’t want to build the same model that every one else is building,” Stanske said.
The firm also don’t bother with investment committee meetings, reasoning that they’re more likely to distract portfolio managers with outdated or uninformed views from people who aren’t following the stocks as closely as they themselves do.
In other words, they think one of the smartest things you can do in investing is eliminate hidden opportunities to introduce mistakes.
2 picks for long-term gains
Asked about companies where experts are making the biggest and most profitable mistakes (for him), Stanske names housewares and home goods maker Helen of Troy. He says it’s beaten Wall Street’s earnings expectations for six quarters in a row, but analysts are only just catching on to its potential.
“They’ve done extremely well in the health area right now with the COVID concerns, but they’ve also done very well with the Hydro Flask, which is in the housewares area,” he said. “[I] just have a lot of confidence in their ability to execute in terms of finding new products, creating new products and bringing them to the marketplace.”
The other is discount supermarket operator Grocery Outlet. He praises the company’s skill in adapting to different markets around the country, which has helped it beat expectations for five consecutive quarters.
“Store managers participate in the gross margin profits of the store. And that kind of thinking gives them opportunities to do a lot of creative stuff. And it also gives them the opportunity to bring in different closeout and grocery items that they would normally not have at all the stores. … It’s a concept that should have a long tailwind.”
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