Hortz: Why then are the majority of managers not using a behavioral investment methodology?
Stanske: Equities represent ownership stakes of listed companies, and as such, their value will be driven by investors’ forecasts of businesses’ future cash flows and/or their estimates of the net asset value of these businesses. Naturally, the vast majority of investors will try to make these forecasts and estimates based on their fundamental analysis, and almost all active investing in the stock market will be driven by this fundamental analysis. This has always been true and will continue to be true in the future. However, this basic fact creates an opportunity for Fuller & Thaler’s behavioral investment approach, which exploits the psychologically driven errors made by these fundamental investors.
How and why the efficient markets hypothesis took hold in academia and investment manager training probably has more to do with the idiosyncrasies and unique dynamics of academia than anything else —a subject that is beyond the scope of our investment process and probably irrelevant to it.
Hortz: How are these sources of alpha and different methodologies holding up in the current market and economic disruptions we are dealing with?
Stanske: The plunge we saw in the stock market earlier this year, the big rally that immediately followed it, and the extreme volatility we have seen throughout shows that nobody really knows what’s going on with the pandemic and the economy in the short term. There’s a difference between reading a lot about the pandemic and being able to consistently predict short-term moves in the stock market based upon what you’ve read, but that is a distinction that many traders don’t seem to grasp. Our behavioral investment approach, which avoids short-term speculation and typically employs longer term holding periods, has generated alpha through a full range of macroeconomic conditions. We expect that to continue in the future.
Hortz: Your firm’s flagship strategy and one of your mutual funds — the Fuller & Thaler Behavioral Small-Cap Growth Fund (FTXSX) — are Small Cap Growth portfolios. You have applied your behavioral methodology in other asset classes, but is there something specific to that stock universe that seems to be inducive to a behavioral approach that made you start there?
Stanske: It is possible that smaller-cap stocks are more prone to mispricing because of their relative lack of attention from investors creates greater market inefficiencies around them. This premise is what led Fuller & Thaler to focus exclusively on small-cap stocks in its early days. While investors make mistakes in asset classes of all types and sizes, we believe they make even more mistakes in small-cap stocks. Why? Besides receiving less attention, there are four times more small-cap stocks than large-cap stocks — providing four times the opportunity set.
Hortz: Can you walk us through the particular dynamics of how you apply your behavioral investment methodology in the small cap growth area?
Stanske: Our investment process is based on decades of research into behavioral finance.
Behavioral finance is the study of how investors actually behave, as opposed to how they should behave, when making investment decisions. Professional investors are human, and like all humans, they make mistakes. Investors make mistakes because they have emotions, use imperfect rules-of-thumb, and have priorities beyond risk and return. We look for those mistakes. We predict when other investors — the “market” — have likely made a behavioral mistake, and in turn, have created a buying opportunity.