Another phase of our research focused on uncovering when corporate managers are consciously or subconsciously hiding lingering doubts about potential problems. We developed a list of deflection statements where the corporate manager is deflecting attention away from something they did not want to talk about or deflecting blame so they will not be implicated. This analysis provides a way to know when management has information they are not sharing or have less confidence in and for looking for unseen problems that have not yet surfaced.
Our Hillcrest management sentiment indicators shows results on finding companies that will outperform, as well as those companies that will have potential problems.
Hortz: Do you continue developing your behavioral models and how have you done so?
Bruce: Members of our investment team have been conducting quantitative research for nearly 30 years primarily focused on rigorously analyzing and evaluating potential improvements to the firm’s proprietary behavioral model in order to better identify companies at the attractive phase of their behavioral cycle.
We have been on a quest for the accurate understanding of all types of sentiment. Continuing research brought the integration of many fields into this investment inquiry — social & group psychology, organizational behavior, psychology, sociology, anthropology, behavior economics, accounting, marketing, science of decision making. This led to my becoming editor-in-chief of the Journal of Behavioral Finance in 2000, where we are publishing ongoing interdisciplinary research efforts and thought leadership from major academics, psychiatrists, psychologists to explain behavior in financial markets. We even promote The Hillcrest Behavioral Finance Award, created in 2014, to seek out and annually recognize excellence in research through the selection of an original paper from academics on the subject of behavioral finance.
Examples of such improvements that have been made over time include the addition of the management sentiment indicator (which we have discussed), adaptive insider and growth likelihood factors. The adaptive insider factor is a behavioral improvement over typical insider scores. We look at the behavior of the management team when buying and selling shares to determine if the trade they are making is due to new information. The Growth Likelihood factor quantifies the reliability of expected growth.
We believe that our firm’s deep experience in both behavioral finance and quantitative research allows us to utilize and develop quantitative tools in a differentiated way and as such is a meaningful competitive advantage. We continually seek to improve upon our process and will incorporate additional factors that show significant predictive powers.
Hortz: How is this behavioral methodology different from a deep value approach?
Bruce: A behavioral investment methodology is based on understanding how the behavior of market participants causes the prices of securities to deviate from intrinsic fair value. It relies equally on valuation, growth and sentiment to identify stocks that are at an attractive phase of their Behavioral Cycle and thus likely to outperform. Applying a sentiment indicator can find turning points in a stock’s behavioral cycle and signals to us when to buy and sell.
A deep value manager buys primarily because a stock is cheap. A behavioralist realizes that if the market doesn’t agree, the manager is at risk of buying a value trap, i.e., a cheap stock that can get cheaper and doesn’t go up in price. On the reverse side, market sentiment can drive stock prices way beyond fundamental valuations for a long time. The behavioral approach makes sure the market agrees through using sentiment indicators before buying and selling. It recognizes that just buying when “cheap” and selling at “fair value” leaves a lot of money on the table.
Hortz: Are there different tools or analysis process being applied that are not utilized by value managers?
Bruce: Conducting quantitative research for over 20 years, we have found that many of the basic ratios and factors used by many investment managers have been arbitraged past the point of being profitable. Therefore, we focus most of our energy on finding new ways to look at investment ideas. In our quantitative process we aspire to use factors that are not commonly used within the quantitative community. We call these factors “adaptive factors.” They are an adaptation of common factors where we add other important considerations or behavioral modifications as we have discussed that allows us to opt for a different group of companies than other quantitative or value managers.