19/9/2018 Bounded Rationality: Tapping Investor Behavior to Source Alpha - 361 Capital

Bounded Rationality:
Tapping Investor Behavior
to
Source Alpha
by John R. Riddle, CFA

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Critics of active management have come by their

skepticism honestly. The average active manager’s
track record against a stated benchmark speaks to the
market’s efficiency, and the difficulty of adding value
to passive alternatives. The problem may lie in the
conventional active manager’s approach. Creating a
better forecast of a company’s earnings and finding
mispriced stocks has proved a fleeting skill for a few
managers, and impossible for most.

We believe a better opportunity to outperform the market comes

instead from anticipating investor behavior. In the following pages,
we explain how behavioral biases shape the expectations around a
company and ultimately influence its stock price. These biases
often lead to a predictable pattern of how investor expectations will
evolve and offer a rare opportunity to capture alpha in an otherwise
efficient market.

Irrational Behavior: A Rare Market Inefficiency

A stock’s price embodies the collective wisdom of the crowd … but
also the biased expectations of a few. If the former is true,
identifying the latter may be one of a very few sources of alpha in
an otherwise efficient market.

Unlike many active investors, we don’t dispute one of the basic

tenets of the Efficient Market Hypothesis: A stock price reflects all
the relevant and available information investors have at their
disposal to project a company’s future cash flows. When new
information comes to the fore that changes those projections, stock
prices simultaneously reflect it. At any moment in time then, a
stock price embodies a company’s consensus forecast, determined
by an entire industry long on CFAs, PhDs and a host of other
impressive designations.
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Most active investors have approached this framework with hubris.

They attempt to outperform the market by creating and acting on
company forecasts they believe will prove superior to Wall Street’s
consensus. That model has come under attack lately from
fiduciaries and financial media alike. Their skepticism is well
earned: As of the first half of 2016, 94.58% of U.S. active
managers underperformed their benchmarks over the last five
years¹. The statistics over longer time horizons are similarly bleak
and paint a stark picture about an investor’s ability to create
superior earnings forecasts.

Even though the market’s ability to reflect knowable information

has made forecasting a perilous task, we believe there is still a
market inefficiency that investors can arbitrage. That inefficiency
stems from a faulty premise underpinning the Efficient Market
Hypothesis: that investors behave rationally. Investment decisions
are complex and uncertain, and even the most sophisticated
investors are influenced by heuristics, cognitive factors and
emotions that introduce irrational, behavioral biases into their
expectations about a company. Those biases often lead to a
predictable pattern of how future expectations will evolve. If
investors can predict how these biases will shape future
expectations, then they may be able to capture excess alpha as the
market responds to changing perceptions. And as it turns out, a
narrow subset of experts provides a guidepost to where
expectations will likely head.

Watching Wall Street: How the Market Sets

Expectations
A stock price reflects the consensus expectations for a company.
The consensus view is largely distilled from Wall Street analysts,
whose expectations are transparent in the form of publicly available
earnings estimates. Revisions to those estimates demonstrate how
an analyst’s expectations are shifting and can be used to project
future expectations. But that information is only valuable to the
extent that the rest of the market follows those expectations.

Our research shows that the broad market follows Wall Street
analysts’ expectations closely. Since we started measuring the
impact of analysts’ earnings revisions on stock prices in 2003,
we’ve found a single revision has had an average 35 basis point
impact on the stock’s price. This research removes the impact of
medium- and short-term momentum, market capitalization,
earnings reports and aggregate sector influences that could affect a
stock price.

The chart below highlights the market’s reaction to changes in

analyst forecasts. The bar on the left shows the stock performance
of companies that reported the largest earnings surprises over the
given time period, while the bar in the middle shows the
performance of companies that had the largest upward analyst
earnings revisions. One might expect that extremely positive
earnings announcements have the largest influence on stock prices.
Not so. Certainly, stock prices move higher when an earnings
surprise is announced, but reactions to analysts’ estimate revisions
are demonstrably larger.
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19/9/2018 Bounded Rationality: Tapping Investor Behavior to Source Alpha - 361 Capital

Wall Street analysts’ influence on market expectations is not that

surprising; humans are hardwired to adopt the advice and follow
the opinions of perceived experts. In any field, be it health care,
academia, politics or finance, we feel more comfortable when our
views align with people we perceive as most knowledgeable. But
here’s what’s interesting: Wall Street analysts fall prey to
behavioral biases of their own. Those biases stem from the arduous
task in front of them.

The Impossible Job of the Wall Street Analyst

That behavioral biases affect Wall Street analysts’ expectations is
no slight on their intelligence. Analysts as a group are highly
educated, diligent, well connected and extremely insightful. They
are asked, however, to perform a remarkably difficult task—one
that doesn’t fit well within the confines of human decision making.

The human mind works quite well within linear parameters. We can
take a single piece of information, or take the outputs from a single
task or variable and correctly use that single output as the input into
the next step of a sequential process. However, humans struggle
with simultaneously assessing many variables and in turn,
developing probabilistically accurate forecasts. Analysts must
consider all the geopolitical, macroeconomic, industry- and
company-specific factors that could influence a company’s
earnings, assign a range of probabilities to those variables and then
combine and weight each variable properly to create a
comprehensive model that will accurately forecast a company’s
revenues, costs, and, ultimately, profits. The task is complex, and
fraught with opportunities for behavioral bias and persistent
forecasting errors.

Faced with this complex and uncertain decision about a company’s

future earnings, rationality meets its limitations. Heuristics and
behavioral biases take over. An analyst may emphasize information
that is more recent or easier to collect, or default to assumptions or
expectations akin to peers following the same company. (See the
list below of common behavioral biases that may influence decision
making.)

Interestingly, the digital economy may be making analysts less

certain about their expectations, allowing behavioral biases to hold
even greater sway. The number of earnings estimate revisions has
leapt 87% since 2003. The growth comes at a time when Wall
Street, and presumably the number of Wall Street analysts, is
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shrinking. The change agent? Technology has made it easier for
19/9/2018 Bounded Rationality: Tapping Investor Behavior to Source Alpha - 361 Capital

analysts to revise, publish and redistribute their new expectations.

This creates a feedback loop that reinforces uncertainty, and begets
one of the more common behavioral biases: herding. As one analyst
observes peers changing their expectations, uncertainty regarding
the individual’s own forecast increases, potentially resulting in a
forecast change by that analyst, which in turn could lead to changes
by additional analysts following the same stock. As the ability to
quickly disseminate earnings forecasts becomes easier, the only
certainty seems to be more uncertainty.

Behavioral Finance Basics: A Primer on the

Impediments Influencing Wall Street
Traditional financial theory is predicated on a well-intended notion:
that investors behave rationally. The rational investor presumably
maximizes profits, possesses complete knowledge and undertakes
action that is consistent with his or her economic well-being.

However, a growing body of behavioral finance research over the

last 40 years suggests that humans have cognitive limitations that
often result in seemingly irrational decisions. A host of biases,
heuristics and emotional factors guide our thinking, often leading to
sub-optimal outcomes. These impediments affect the most novice
and the most professional investors alike. Below is a primer on
common behavioral finance concepts that can affect decision
making, and how they may influence Wall Street analysts.

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Are Behavioral Biases Predictable?

Thus far, we’ve shown how Wall Street analysts drive the market’s
expectation about a company, and in turn, its stock price. We’ve
also explained how and why behavioral biases creep into a Wall
Street analyst’s expectations. The material question for investors,
however, is whether analysts’ biases and heuristics result in
predictable behavior about their future forecasts. The serial
correlation of their forecasts suggests a significant level of
predictability.

If behavioral biases don’t influence analysts, one would not expect

serial correlation in their estimates from one period to the next. If
analyst forecasts are efficient in an economic sense, then
macroeconomic, industry-relative and security-specific events that
affect a company should be randomly positive or negative relative
to prior expectations. As such, earnings estimates based purely on
new economic and industry data should not exhibit serial
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correlation between a prior estimate and the next; analysts are just
19/9/2018 Bounded Rationality: Tapping Investor Behavior to Source Alpha - 361 Capital

as likely to receive new information that would lower the next

estimate as they are to receive information that would raise it. But
if behavioral biases affect their expectations, for example if an
analyst over-emphasizes more recent information or is influenced
by the forecasts of other professional analysts, one might expect
serial correlation in their estimates.

The two charts below examine serial correlation in analyst

behavior. The first chart examines serial correlation of behavior at
the individual stock level, using Intel Corporation as an example.
The dots on the blue line indicate the net percentage of analysts
who either raised or lowered their earnings-per-share forecasts for
Intel each month.

At first glance, the variation between dots would suggest the

analysts’ estimate changes are random, influenced solely by new
economic or company-specific information. Some months, nearly
100% of analysts revised their estimates up. In the following
month, a large percentage of analysts might revise earnings down.
Indeed, analysts do respond to new information in the market. If,
for example, Intel announced a defective product or a
macroeconomic report points to less microprocessor demand in the
coming months, an analyst will incorporate that information into a
new earnings estimate. The variation in blue dots captures these
instant reactions.

The green line, however, suggests that beneath the monthly

fluctuations in earnings forecasts, a pattern of serial correlation
exists. The line represents the serial correlation between the
analyst’s current forecast and the forecast three months prior over a
rolling four-year period. A degree of serial correlation exists in
every period except the height of the Financial Crisis. Over the
course of the 10-year study, the average serial correlation was 0.3.
This means that in the case of Intel, the analysts’ prior earnings
forecasts did indeed give an indication of how they would revise
their earnings forecasts in the future.

Intel is only one stock. The next chart shows how many stocks
within the Russell 1000 Index have exhibited a high level of serial
correlation in analysts’ earnings estimates. Serial correlation has
not been observed in the earnings forecasts of every stock.
However, as of November 2016, 74% of companies in the test
universe exhibited positive serial correlation in behavior, and for
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nearly half of these companies the degree of correlation in their
19/9/2018 Bounded Rationality: Tapping Investor Behavior to Source Alpha - 361 Capital

earnings forecasts was high enough that we can say with 95%
confidence that the results were not due to random variation. At
times over the past decade, as much as 60% of stocks in the index
have exhibited this high level of serial correlation. The portion of
stocks exhibiting this statistically significant level of serial
correlation has never dipped below 40% over the period tested.

Markets Don’t Anticipate Predictable Analyst

Behavior
Even though the behavioral biases of analysts lead to significant
predictability about their future expectations, the market has done a
poor job of pricing in these evolving expectations. The inability to
account for those biases presents a rare inefficiency in a market that
is otherwise ruthlessly efficient at pricing changes in stock-specific
characteristics. The chart below demonstrates this inefficiency, and
the value of predicting analyst behavior over time.

The chart encapsulates the average price movement of a stock on

the day analysts revise their earnings forecasts for a company, and
the price movement for the 120 days afterward. The data for this
model includes every instance in which more than 10% of the
analysts covering a given stock in the Russell 1000 revised their
earnings forecasts upward or downward (which we refer to as a
positive or negative “behavioral event”) over the 2010 to 2015
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study period. As expected, stocks experience a notable rise or fall

the day of the positive or negative behavioral event.

The drift upward in the months after a positive behavioral event

(and downward after a negative one) demonstrates the serial
correlation inherent in analysts’ behavior, and the market’s failure
to fully account for the embedded information in these forecast
changes. After one positive behavioral event, there is a tendency for
more positive forecast changes to follow as individual analysts
influence the behavior of other analysts following the same
security. Similarly, after a negative behavioral event, more negative
forecast changes tend to follow. Contrary to what one would expect
in a completely efficient market, prices persistently drift in the
same direction as the prior behavioral event. Investors appear to
view each behavioral event as an isolated occurrence, driving the
stock higher (or lower) each time a new positive (or negative)
behavioral event takes place.

If there was no serial correlation in analysts’ behavior, or if the

market correctly priced the predictable components of analyst
behavioral events, stocks would not demonstrate an upward trend in
price appreciation in the months following a positive behavioral
event. The market’s inability to account for analysts’ behavior
creates an opportunity for investors: A strategy of purchasing
stocks with observed positive analyst behavior may provide excess
abnormal returns as subsequent behavior exhibits predictable
herding characteristics.

Conclusion:
We’re uncertain about the ability of active managers to consistently
create superior forecasts relative to consensus estimates already
incorporated into stock prices. A better approach to active
management may be to acknowledge uncertainty. Thousands of
variables can affect a company’s earnings, and no one can say with
conviction what cash flows might be one, two or even three years
into the future. Faced with the Herculean task of crafting an
estimate that incorporates so many variables, Wall Street analysts,
like all of us, are influenced by a myriad of heuristics and cognitive
factors that introduce behavioral biases into their expectations and
forecasts. The result: demonstrable herding characteristics and
serial correlation in analysts’ estimates.

While herding behavior and other biases often lead to a level of

predictability in Wall Street analysts’ future expectations for many
companies, the market often fails to price this information
efficiently. Instead, stock prices tend to move higher following a
significant earnings forecast revision upward, as if each revision
was an uncorrelated event. We believe predicting the positive
trends of influential security analysts is a more reliable way to add
alpha than attempting to out-forecast the market with respect to
which companies will experience earnings superior to the collective
estimate implied in their stock prices.

Learn more about John Riddle >

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Key Takeaways
The traditional approach to active management has let investors
down. Few, if any, managers can consistently forecast a company’s
earnings more accurately than the collective forecast implied in a
stock price.

Anticipating investor behavior may provide a better approach to

outperforming the market.

Behavioral biases influence even the most expert investors, and often
create a predictable pattern of how future company expectations could
evolve.

If investors can predict how these biases will shape future

expectations, they may be able to capture alpha as the market
responds to changing perceptions.

¹ SPIVA (Standard Poor’s Index Versus Active) U.S. Scorecard, as of 06/30/2016.

² A.G. Schick, L.A. Gordon, and S. Haka, “Information Overload: A Temporal Approach,” Accounting, Organi¬zations and Society, vol. 15,
no. 3, 1990, pp. 199–220.

The views expressed are those of the authors at the time created. These views are subject to change at any time based on market and other
conditions, and 361 Capital disclaims any responsibility to update such views. No forecasts can be guaranteed. These views may not be relied
upon as investment advice or as an indication of trading intent on behalf of any 361 Capital portfolio.

This 361 Capital article is not intended to provide investment advice. This paper should not be construed as an offer to sell, a solicitation of
an offer to buy, or a recommendation for any security by 361 Capital or any third-party. You are solely responsible for determining whether
any investment, investment strategy, security or related transaction is appropriate for you based on your personal investment objectives,
financial circumstances and risk tolerance. You should consult your legal or tax professional regarding your specific situation.

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