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Selling Winners And Holding Losers – Even The Smartest Investors Get It Wrong

The study of how human instinct impacts on investment decisions is hotly debated and sometimes controversial. But even Ben Graham, the father of value investing, was aware of the potential for investors to err. He famously warned that “the investor’s chief problem – and even his worst enemy – is likely to be himself.” One of the best known behavioural trap-doors is to hang onto losing investments for too long and sell winning positions too soon. It’s a phenomenon known as the Disposition Effect. For years, researchers have warned that investors can damage returns by cutting winners and riding losers. Often, this warning has been pitched in the direction of relatively unsophisticated retail investors. But new research suggests that the same behavioural flaw exists in some of the market’s smartest and best-informed traders – Short Sellers. It serves as a reminder that the risk of succumbing to selling the wrong positions is something every investor needs to be aware of. So here’s a review of how things can go wrong and why smart investors are susceptible too. Why we sell the wrong shares If you were looking at a map of behavioural finance, you’d arrive at the Disposition Effect directly from two other places: prospect theory and mental accounting. These are theories about how humans make choices between risky prospects and how they categorise them based on different outcomes. In the context of investing, these theories claim that investors treat the probability of a loss differently to that of a gain. With the Disposition Effect, what this means is that investors irrationally sell winners and hold losers even though it often makes no economic sense. Some of the best research into the consequences of all this was done by Terrance Odean, who waded through 10,000 accounts held at an American discount broker between 1987 and 1993. He found a clear tendency for investors to sell winning positions over losing positions. Moreover, there was no good reason for it – there was no evidence that these investors were deliberately rebalancing their portfolios. On average, after one year, the losing stock, that was held, fell by 1.0% against the market. While the winning stock, that was sold, actually gained 2.4% above the market. Momentum rides on the Disposition Effect Clearly, Odean’s findings show that the Disposition Effect can damage performance – but not everyone loses. Readers of Stockopedia will know that we view Momentum as a core driver of market returns – as do a number of academics and investment professionals. So it’s worth mentioning at this point that the Disposition Effect arguably has a role in driving momentum. Given that research shows that investors sell winning positions too soon, there’s a read-across to companies that issue good news to the market. Some evidence suggests that the share price rise that goes hand-in-hand with good or surprising news can be artificially held back. And it’s held back by investors succumbing to the Disposition Effect and selling out of those ‘good news’ stocks too early. It causes something called post-earnings announcement drift, where the market takes a protracted time to price in the full meaning of the good news. This is one of the ways that momentum has been shown to work – very successfully for those who catch the wave. Smart investors make the same mistakes! If all this sounds a bit like like academics have been nit-picking at the fallibilities of individual investors, think again. In the evolutionary tree of the stock market, Short Sellers (despite their opaque nature) are regarded as some of the smartest investors around. Geared up to bet on shares that will fall in price means that they have to operate with a high degree of confidence. Ultimately, that means deep pockets and very detailed, industry-leading research. But very recent analysis shows that these guys are equally susceptible to the Disposition Effect. Watch out, we’re straying into the realms of double negatives here… but the evidence shows that short sellers are more prone to realising a capital gain on a falling share then they are to cut a losing position (i.e. a share that has risen in price). This is interesting stuff, not least because it hasn’t been looked at in detail before. In particular it shows just how powerful this natural urge to cut a winner really is. Plus it casts a small shadow over just how effective short selling is at making markets more efficient by pricing stocks correctly. The implication is that short sellers unwind profitable positions before they really should, or could do. The research was done by Bastian von Beschwitz (an economist at the US Fed) and Massimo Massa (a professor at INSEAD business school). They studied shorting activity on all US stocks between mid-2004 and mid-2010. Given the assumption that short sellers are very smart, there was a suspicion that they held on to losing (poor performing) positions because they knew they’d eventually come good. But it turns out this wasn’t the case – there was an element of irrational behaviour. Those profitable losing stocks became more profitable even after the short sellers had cut and run. As the researchers concluded: “…short sellers are closing more positions exactly at the time when it would be profitable to keep the short position open and profit from the negative future return. Thus, their tendency to hold on to their losing positions and close their winning ones causes them to lose money, a clear sign that it is not a profit maximizing strategy.” Circling back to the momentum connection, this new research also suggested that the Disposition Effect behaviour leads both long traders and short sellers to add to momentum. What can investors learn from this? For individual investors, news that the market’s most ruthless traders are prone to the same behavioural bias is perhaps quite reassuring. Unfortunately, it appears that individuals are more susceptible. Comparing Terry Odean’s 1998 research with their own, von Beschwitz and Massa found that the average retail investor suffered from a Disposition Effect that is approximately 6 times as strong as that of the average short seller. Overall, the findings reinforce many years of research that shows that selling winners too soon and holding losers too long can be costly. Dealing with this, of course, is another matter.

Momentum Traps – How To Avoid The Siren Song Of Overhyped Stocks

Faced with choosing between a $10 bottle of wine and a $90 bottle of wine, which would you go for? In one experiment – with the prices of each wine clearly marked – nearly twice as many people preferred the taste of the most expensive bottle. But unknown to the volunteers, the two wines were exactly the same. This test was carried out by American researchers investigating how pricing can influence the brain’s perception of how ‘pleasant’ something is. Told it’s expensive, we tend to like it all the more. It’s an example of what behavioral scientists say is a flaw in human emotions that causes us to be overly-influenced by a good story. The read across for investors could hardly be more stark. Stories in the stock market are like a magnet. With herds of followers, these popular shares typically boast eye-catching price momentum. Yet a good proportion of them hide deteriorating fundamentals and stretched valuations that can be harder to spot (and, for some, easy to ignore). These are the market’s glamour stocks which may well be Momentum Traps – stocks where a sudden change in sentiment could see their momentum crash. Of all the dangers that investors face, perhaps none is more seductive than the siren song of stories. Stories essentially govern the way we think. We will abandon evidence in favour of a good story – James Montier Signs of a Momentum Trap Small cap stocks soared through 2013, and by early the following year some valuations looked frothy. Swept up in a wave of bullish exuberance, popular ‘blue sky’ companies like Blur ( OTC:BLURF ), Monitise ( OTC:MNQQY ) and Cloudbuy ( OTC:CDLBF ) were showing some of the classic signs of being momentum traps. As sentiment towards small caps drifted through the next 12 months, the price of each share was pummelled. The common traits shared by these and other momentum traps was that their strong price momentum hadn’t been matched by improving fundamentals. Yet, they looked expensive and their low QualityRanks pointed to firms that either weren’t profitable at all or were flagging as potentially distressed. Importantly, these were some of the most talked about small caps at the time, promoted by brokers and heavily traded by investors. They were the polar opposite of traditional ‘value’ shares but investors lapped them up all the same. In The Little Book of Behavioural Investing , James Montier of investment firm GMO, says that one of the reasons why people shy away from value investing is that value shares tend to come with poor stories. As a result, they end up being despised rather than admired. He explains: “Which would you rather own? Psychologically, we know you will feel attracted to the admired stocks. Yet the despised stocks are generally a far better investment. They significantly outperform the market as well as the admired stocks.” Indeed, evidence that momentum stocks underperform dates back to a 1993 study by three researchers who made a personal fortune from their findings. Josef Lakonishok, Andrei Shleifer and Robert Vishny showed that investors consistently overestimate future growth rates of glamour stocks relative to value stocks. They said this was because investors typically make judgement errors and extrapolate too much of the past to make predictions about the future. They proved their point by going on to run billions of dollars in their own fund management firm called LSV. Testing the performance of Momentum Traps In Stockopedia’s taxonomy of stock market winners (and losers), Momentum Traps typically have StockRanks that reflect strong momentum but poor value and quality. We can build a screen for these stocks by setting the following filters: Momentum Rank > 80 (i.e. high Momentum) QV Rank < 40 (i.e. poor combined Quality and Value) Market Cap > 100 (i.e. to focus on the more well-known shares) Top 25 stocks by Momentum Rank (i.e. 25 highest Momentum shares in the set) We’ve used the Stockopedia StockRank archives to generate the performance history of a 25 stock portfolio rebalanced annually since April 2013. The results are quite startling (click to enlarge) What happens so often with Momentum Traps is that they outperform the market dramatically… but only for a while. This strong price performance lulls investors into a false sense of security and draws in the suckers right at the wrong time. Most investors buy these stocks at the top, and suffer terrible underperformance when gravity reasserts itself. As we can see, the Momentum Trap portfolio has tracked the FTSE All Share over the last two-and-a-half years but broken everyone’s hearts in the interim. Through 2013, the Momentum Traps portfolio was very much an all-cap affair, with stocks ranging from 3i ( OTCPK:TGOPY ) to Nanoco ( OTC:NNOCF ) and Blinkx ( OTC:BLNKY ). There were (and continue to be) some stocks that held on to the momentum and did well. But in 2014, it was weighted much more heavily towards small caps. It’s here that the trouble starts. As sentiment cooled towards smaller stocks, those that were overstretched paid the heaviest price. Companies like eServGlobal, Quadrise Fuels ( OTC:QDRSF ), Johnston Press ( OTC:JHPSY ) and a handful of resources shares have continued to slide. Dodging a momentum trap bullet Using the above rules on today’s data set, we’ve compiled a list below of stocks that could see their momentum turn if investor sentiment changes. The companies include some popular names like Hutchison China MediTech (Pending: HCM ) and Optimal Payments ( OTCPK:NVAFF ). Note that the ‘buy’, ‘hold’ and ‘sell’ recommendations of the brokers that cover each company are broadly positive in their outlook. Detailed research may uncover nothing to worry about with these shares. However, QV Ranks of below 40 (out of 100) certainly warrants close attention and suggests things could be more precarious than the broker recommendations infer. Name Momentum Rank QV Rank # Buy Recs # Hold Recs # Sell Recs Admiral ( OTCPK:AMIGY ) 98 25 1 10 2 OneSavings Bank ( OTC:OSVBF ) 98 29 – 4 – Hutchison China MediTech 96 14 – – 1 Optimal Payments 95 29 4 – – Grainger ( OTC:GRGTF ) 94 10 3 4 – Severn Trent ( OTCQX:STRNY ) 94 25 2 9 1 NMC Health ( OTC:NMHLY ) 93 20 6 – – Dignity ( OTC:DGNTY ) 92 37 – 4 – To avoid the lure of stories and the risk of succumbing to momentum traps, investors should be alert when strong momentum is paired with deteriorating fundamentals or excessive valuation. Momentum is one of the strongest drivers of returns in the stock market, and certainly capable of carrying story stocks some distance. But momentum can crash, particularly in shares with heady valuations and suspect quality. It’s a message best summed up by Montier, who says the key is to focus on facts. “Focusing on the cold hard facts (soundly based in real numbers) is likely to be the best defence against the siren song of stories.” Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

High Flyers – How To Beat The Market In Expensive And Highly Priced Shares

Last week Domino’s Pizza (NYSE: DPZ ) broke out to yet another stunning new high. This is a share we bought at 75p in 2004 for our family investment club and I’m proud to say we still hold. It’s now trading at 1043p per share making it a 14 bagger over an 11-year period – a 27% annualised capital return before dividends. Domino’s hasn’t just been a long term winner…. it’s been a standout performer in almost every two-year period since it first bounced up from its lows back in 2001. Even in the last two years, this stock has doubled in price and in all this time it’s almost never, ever been cheap . Since the financial crisis, I don’t think Domino’s has traded beneath a price earnings ratio of 23, which begs the question of when on earth could a value investor have ever bought this share? If value investors admit they couldn’t, then isn’t there something that they are missing? (click to enlarge) The problem with value investing We human beings are genetically hard-wired to look for bargains. If you can pick something up for less than it’s worth, you might just have a happy outcome and a few spare pennies in your pocket to boot. It’s a strategy that works in the flea market and it works just as well in the stock market. Buying cheap is the core tenet of value investing – the strategy that has minted thousands of stock market millionaires and quite a number of billionaires too. But there’s a problem at the heart of value investing which leads to a certain blindness. Value investors have an inability to consider any stock that is even remotely pricey. Take a look at this chart and you’ll understand why. (click to enlarge) The chart shows the performance of the cheapest 20% of the stock market (green line) vs. the most expensive 20% of the stock market (red line) over the last 2 years according to the Stockopedia Value Rank. There’re about 200 stocks in each of those portfolios, but the cheap set of stocks has outperformed the expensive set by a massive 32%. These results, from the last few years in the UK, are very typical for stock markets. Cheap shares tend to outperform expensive shares. So any rational investor, when asked to pick a winning portfolio of 50 stocks, would most likely go shopping amongst the higher probability set of shares… the cheap ones…. right? Lies, Damn Lies and Statistics Well herein lies the blindness, and perhaps naivety of value investors. You see, nestled amongst that set of expensive shares lie some of the greatest companies listed on London Stock Exchange including Dominos’ Pizza, Betfair ( OTC:BTFRF ), Abcam ( OTCPK:ABCZY ), Next ( OTCPK:NXGPF ) and Rightmove ( OTCPK:RTMVY ). These companies have trounced the market for years, and most likely some of them will continue to trounce the market in the coming years. As I’ll be illustrating, there’s a set of 25 shares that could have been very easily selected using the tools at Stockopedia. This portfolio has managed a total return of about 60% over the same time period – a performance that has crushed the 30% average returns of the ‘cheap’ portfolio of value stocks and made a mockery of the -2% returns of the ‘expensive’ portfolio. Averages, you see, can be highly deceptive – some expensive shares really are worth it. While I hope to show that it’s surprisingly easy to pick them, for value investors the process requires a bit of a mind shift. So let’s go a bit further down the rabbit hole to find out why. The trick to pick’em – a brief interlude There’s a trick to picking winners from the pool of expensive shares and it comes down to having a solid understanding of the key factors that drive stock returns. Academics bicker and fight over which factors are the most important, but in a nutshell, we can simplify the most powerful to the following three which also make up the core triad behind the Stockopedia StockRanks: Quality – i.e. good shares tend to outperform junk shares. Value – i.e. cheap shares tend to outperform expensive shares. Momentum – leading shares tend to outperform lagging shares. If you imagine driving a go-kart, you can propel yourself in three different ways – with an engine, using gravity or just by continuing to free-wheel. These three forces are analogous to the quality, value and momentum forces that drive share prices in the stock market. Now in the perfect scenario, one might like to find shares exposed to all three drivers, but in fact all three aren’t necessary. Take one of these drivers away and the other two work just fine without it. Value investors tend to solely focus on just two of the drivers, quality and value . They can be thought of as ‘ Contrarians ‘ who look to buy good shares cheaply and don’t mind price action to be weak as it gives them a chance to buy shares when they are marked down. It’s a smart strategy and a profitable one, but it’s a strategy that will never allow them to own a stock like Domino’s Pizza. Contrarians may not realise it, but they are deliberately removing momentum from their model of the universe which may be a costly oversight. In just the same way, there is a less popular, but just as profitable strategy that removes the concept of “Value” from its model of the universe. By focusing on investing in the highest quality, highest momentum shares regardless of price, it’s quite possible to trounce the market. We christened this set of shares ” High Flyers ” earlier this year in a blog post titled ‘ The Taxonomy of Stock Market Winners ‘, but it’s a strategy that’s been used by some of the greatest investors of all time. If we use the Stockopedia StockRanks, we can see the effectiveness of this approach over the last few years. The following chart was created using the High Flyer Stock Screen to build a portfolio first selected in April 2013 and rebalanced annually in April. It simply searched for shares qualifying for the following criteria: Market Cap > £100m (i.e. no microcaps) Value Rank < 33 (i.e. expensive) QM Rank > 90 (i.e. high quality, high momentum) Top 25 by QM Rank. (click to enlarge) This is a portfolio that has had an average P/E ratio of over 30 with the most expensive stock’s P/E ratio at times being over 100! To those value investors who have only a narrow view of the universe that seems an extortionately high price to pay. But clearly, under certain circumstances, ignoring P/E ratios can be a completely rational thing to do with a high probability of favourable outcome. The portfolio listed above showed a capital return of 55% over two-and-a-half years at an annualised return of 19.0%. High flying investing greats So who are among great investors who have had the instinct to invest in High Flyers? One of the first advocates was the wildly successful fund manager Richard Driehaus who was profiled in Jack Schwager’s excellent book “The New Market Wizards.” Driehaus looked at the common attributes of spectacular stock market winners and realised he could never buy them on low P/E ratios. ” Many of the best growth stocks have high multiples and are psychologically difficult to buy .” So he tore up the rule book and looked for high quality, high momentum shares. His anti-value strategy was summed up in this quote: One market paradigm that I take exception to is: Buy low and sell high. I believe that far more money is made buying high and selling at even higher prices. That means buying stocks that have already had good moves and have high relative strength – that is, stocks in demand by other investors.” It worked very well for Driehaus who generated 30% annualised returns over a 12-year period. Beyond Driehaus, one of my favourite authors is William J. O’Neil, who wrote ” How to Make Money in Stocks ,” which I thoroughly recommend to all investors. O’Neil spent years analysing what worked in stock markets, and bought a seat on the NYSE from his trading profits. He went on to found investors.com and publish Investors Business Daily – both excellent resources for US bound investors. O’Neil famously disregards the P/E ratio completely. For years analysts have used P/E ratios as their basic measurement tool in deciding whether a stock is undervalued and should be bought… but our ongoing analysis of the most successful stocks from 1880 to the present shows that P/E ratios were not a relevant factor in price movement. In his analysis of the greatest stock market winners of all time from 1953 through to 1995, he found that: the “beginning P/Es for most big winners ranged from 25 to 50, and the P/E expansions varied from 60 to 115” . In other words, if you really wanted to find the great stocks you had to be willing to completely ignore traditional measures of value. The nitty gritty – resources, ratios & metrics that can help hunt for High Flyers So if you don’t have access to the StockRanks how can you isolate these potential big winners amongst expensive shares ? Well they tend to share certain attributes which can be easily screened for using a good data source like Stockopedia. We’ve discussed Quality and Momentum – but those concepts need to be a bit more closely defined so here’s a few links to some of our screening library data which may be of use to the curious: In general terms – a Quality company is one that is highly profitable (ROCE, ROE, GPA ) with high industry leading margins, stable, growing and ideally accelerating sales and earnings, with a strong and improving fundamental trend (F-Score), a good shareholder payout (Yield, Buybacks) without having any risky red flags (e.g. Bankruptcy risk, Earnings Manipulation Risk or Share price volatility). A Momentum stock is one whose share price is up or above its 52 week highest price, is within the top 20% of share price percentage winners for the last 6 or 12 months (using Relative or Absolute Price Strength), is beating broker estimates (earnings surprise) and seeing estimate upgrades and recommendation changes. Some of my favourite stock screens for finding these kinds of shares include the Richard Driehaus Screen and the CAN-SLIM-esque Screen , both of which have massively outperformed the market in recent years. I’ve also linked to our own proprietary StockRanks generated High Flyers Stock Screen. I am not going to list all the current qualifiers as that would be unfair on Stockopedia subscribers but the list of 61 current High Flyers makes fascinating reading. These really are some of the UK’s most excellent businesses, but of course they are highly prized by the market and very expensive! Where high flyers go next…. There are a few words of caution needing here. These kinds of shares tend to be more volatile than the market and as they have high price momentum they can suffer reversals more strongly than the overall market. This is clear to see in the performance chart above. In my own experience, few shares can stay a High Flyer for too long – especially in the UK as the market just isn’t as big as in the USA. Companies that do, like Domino’s Pizza, are the exception, rather than the rule. Most will spend a couple of years as a High Flyer before one of two things happens – either the stock or the company runs out of steam. So running a portfolio like this requires active management – regular portfolio rebalancing to keep jumping into the next set of High Flyers before the previous set runs out of steam. Expensive shares are very fragile as the market has high expectations for them. If those expectations are not met then the market reaction can be brutal. ASOS ( OTCPK:ASOMY ), the famous online fashion retailer, is a classic example. This stock soared, at times trading at beyond a P/E ratio of 100. But when the company finally disappointed, the shares were decimated falling by something like 65% till they bottomed. (click to enlarge) 1. High Flyers can become Falling Stars In ASOS’s case, the broker expectations proved too high, so the share price ran out of steam (falling momentum). This left it as a high quality company on a very expensive valuation with sentiment turning against it. Finding a floor under a stock with this profile is hard as P/E ratios can contract dramatically. We call this profile of stock Falling Star and it’s one of the worst places to be as an investor. 2. High Flyers can become Momentum traps The other, less usual, place for a High Flyer to end up is where the fundamentals deteriorate but the share price (momentum) keeps on trucking. These are known as Momentum traps and are most often seen in bubble periods where the market divorces itself from fundamental reality. The final caution is that there are more stocks qualifying as “High Flyers” than I’ve seen in three years, so it may be that chasing these stocks is becoming a crowded trade. Final Words So my general rule of thumb with High Flyers is to watch them like a hawk, and sell as soon as price momentum or fundamentals turn. If you are really sure that the shares have a rock solid economic moat , and the valuation isn’t too stretched then it’s possible to continue to hold these shares through corrections. Your share may turn out to be a magical, multi-year compounder like Domino’s Pizza, the kind of share that comes along only a few times every decade that we’d all love to build our portfolios around. That kind of masterful judgment, I have to admit, I have long given up on. In the introductory paragraph I boasted about owning Domino’s Pizza in my investment club. Let me sign off by humbly admitting the reality. The only reason we still own it is because the club hasn’t met since 2005. If we had, we’d definitely have sold it. Sometimes it pays to do nothing! Safe investing. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.