Tuesday, November 15, 2011

The biases of value investors..

Value investors are considered to be a class apart. They do things differently, they have their emotions under control and they make fantastic returns over longer periods of time. We have n number of examples to substantiate the same. Listen to Buffett's interview vis-a-vis a broker or an analyst or a hedge fund manager's interview and you will agree!
On the blog, I have discussed quite a few examples of biases and mental screw-ups that investors face. (The articles can be found under the 'behavioural finance' label on the right hand side of the blog). Well, value investors are supposed to be well aware of these biases and generally avoid them. But they are humans after all and it got me thinking as to what other biases specifically affect the value guys?
My thoughts on this topic are based on observations of my own behaviour/thought process and that of others whom I consider to be value-oriented investors and with whom I interact. I agree that a specific value investor may not be prone to all the biases listed and also that there may be other biases out there affecting value investors. I would like to add that I am (and probably will be) very much a victim of some of the biases listed below. So lets try and take the mask off the value investors eh? :-D

The 'absolute cheapness' bias
Followers of Graham will especially understand what I am saying. Typically, value investors run screeners to find stocks that are quoting at absolute cheap valuations; e.g. PE ratio of less than 8 times etc. Of course, it is just a starting point, but I have rarely seen investors of this breed being comfortable with valuations of 30-40 times. Even value investors who take investing decisions exclusively based on a company's business model and not just numbers like PE ratio will flinch at the thought of a stock quoting 40 times trailing earnings. The flip side of this bias? Focus on absolute cheapness might lead to missing the bigger picture or ignoring hidden assets of a company which are currently not earning anything.

The 'under-researched stock' bias
A large number of hard core value investors I know enjoy the process (of finding an opportunity) more than the result (profit/loss). Everybody loves profit, of course! :-) But because of this inclination towards the process, lot of value oriented people are obsessed with trying to discover something new, trying to catch something that the market has not understood. There lies their 'kick'. How many value investors will try to discover value in an Infosys or a Tata Steel? As a result, value investors enjoy digging into unknown companies' ARs and trying to find value. The flip side of this bias? Such value investors will miss a 'well covered' stock, like a large-cap, which sometimes becomes a 'sitter' due to Mr.Market going bonkers!

The 'conservatism' bias
Value investors have a licence to be conservative! :-) Lots of them can be also classified as pessimists too! Of course, when a pessimistic guy finds an attractive idea and loads up on it, results can be fabulous. Of course, this wont happen very often, but thats ok! I feel 1 or 2 ideas in an year, in which you can load up is quite ok! The flip side of this bias? Lotsa opportunity losses because the 'conservative' value investor let it go; and selling the stock too early, because the 'conservative' value investor thought the stock has become 'overvalued' too early.

The 'sometimes the best thing to do is to do nothing at all' bias
I feel this is one bias behind which value investors hide when they are actually scared and afraid! It becomes nothing but a mental justification. E.g. a value investor might be actually scared that the market will fall because of debt in Europe, unemployment in US, interest rates in India, real estate in Middle East, fudged data in China and coz there are too many craters on the moon. So, he might not buy a stock he thinks is really cheap, so that he can buy it lower when the market falls! What he is actually doing is trying to time the market but the mental justification to this is 'sometimes inaction is the best action'! This is a very very dangerous bias and will surely lead to confusion, incorrect decisions and overall misery!

The 'bad management' bias
Without taking any names (for my protection), there are certain families or groups which are considered to be 'bad managements' due to their past activities and history. Now I have to mention something, which happens lotsa times: someone says that ignore this company, its a bad management. I ask why is it bad? And the answer usually is 'someone told them' or 'its generally said that they are bad'. Very few times, people give sensible reasons as to why is a particular management bad. Usually, they just 'think' that its bad, thats all! Value investors are usually ethical people and they wont want to earn money in a 'wrong' way. Well I also agree with this and while there are certain groups whose companies I wont touch, having this in-toto mindblock may sometimes lead to some really good opportunities being lost. Managements might change, new generation might take over which is radically different. Keeping an open mind (but an alert brain) helps!

The 'ignore macro stuff' bias

A lot of value investors I know take investing decisions based purely on valuations and not based on macro scenario. This has its pitfalls too. e.g. interest rates affect own discounting rates, industry scenario will change our growth assumptions. I personally am not very great at analysing macro stuff, but totally ignoring macro happenings will lead to incorrect decisions. I think that a fine line is to be maintained here as per one's inclination as well as ability to understand and analyse macro economic data.

The 'circle of competence' bias
We all have heard Buffett and Munger talk about the circle of competence n number of times. It essentially means; identify what you are good at and what you know, identify what you are not good at and what you dont know and then just stick to the former! But some lazy value investors escape taking efforts by saying that something is 'out of my circle of competence'. e.g. I give the very same answer when someone asks me about any pharma company, saying that I do not understand pharma. Now what stops me to get off my behind, read read read and understand pharma? Nothing! But I still havnt done it! So this is a good justification for my laziness right?! Btw, this also raises the debatable topic of should one be comfortable with a COC or should one go about expanding it?! This topic probably deserves an independent post! :-)

The 'we have to do things differently' bias
I have experienced some value investors having this kida and compulsion of doing things differently. They have this OCD to be different all the time. I agree that being different is a good trait of a value investor, but bring different, thinking differently and acting differently just for the heck of it doesn't make sense! The flip side of this bias? You will frustrate people you talk with and they might probably hit you on the head with something. On a serious note, such investors will make a simple straight forward decision complicated and make a mess of things!

Well there you have it! Some biases that I think value investors face. I do not claim that all of these biases are undesirable and should be avoided. Some of them are very much desirable, depending on the kind of investor you are. But what is important is to recognise these biases, identify whether a bias exists in yourself and to watch and monitor it carefully. See to it that it doesn't cloud your decision making process.

Cheers and happy (value) investing!!


Anonymous said...

Just to add to this

The " I will close my mind to anything said by anybody other than a fellow value investor" bias

Neeraj Marathe said...

LOL...ya i will have to say i agree!

Mahesh said...

I must say that you nicely captured most of the commonly observed biases amongst value investors!

Neeraj Marathe said...

Thnx Mahesh for your kind words..

Siddharth Shukla said...

Brilliant post as usual neeraj. Another one that i typically succumb to is : anchoring to 52 week low/3/5yr low price. Any stock near those suddenly seem to appear like bargains.

Neeraj Marathe said...


Anonymous said...

Great post Neeraj.

Another one for the list...the 'Holier than thou' bias?


Anonymous said...

Very good description of common follies.

It's high time to say "bye bye bias"



sameer said...

Hi Neeraj,
One way to spot multibagger is to understand potentials of reforms and invest in sector leaders.
Lot of reforms have lined up especially GST. Whats your views on coming reforms and sector that we can look into.For example 1)The Telecom Regulatory Authority of India (TRAI) has recommended the road map for complete digitalization of the cable industry in a phased manner, with sunset date of December 31, 2013. What is ur best pick in this. Also whats ur view on Den Networks, Hathway Cable & Datacom and Wire and Wireless 2)Boost in logistic in reveue especially arshiya's FTWZ(becauze of foreign land policy) 3) FDI in multibrand retail etc
It will be great if u have special post coming reforms. It wil be great to know views of value investor like you

Manish said...

It was a fun post but then if you follow certain principles of value investing then you are supposed to have certain biases. And, i feel if you stick to them then although you may miss out on certain opportunities but you will surely discover few others that can serve you well. You can't have a philosphy and then not have one at the same time.

On the lighter side, 'Thinking too much about biases is also a bias'. ;)

Neeraj Marathe said...

Hi Sameer,
the only sector i have started studying recently is the logistics sector..i hvnt looked into rest of the opportunities you have mentioned.

Neeraj Marathe said...

Hi Manish,
Yes i absolutely agree that its ok to have some of the biases..my point is that one should be aware that such biases exist, so that decision making process wont be biased! :-)
And a big lol to the new bias u have introduced..its kinda a loop! :-)

Kiran said...

Fantastic post. Bookmarked!

I guess another bias is 'over-researched bias' - where you say, boss I invested a lot of time on this stock...hence, kuch to paisa daalna hi hai. Actually, on second thoughts even that is better than modifying assumptions and self-convice yourself that it is a multi-bagger just becoz you overresearched it :)

Rohit Chauhan said...

Hi neeraj
great post. i felt you were describing me :)


Neeraj Marathe said...

:-) Ya Rohit, it describes us all in bits and pieces..
btw, u will also agree with the 1st comment on this post..its by a mutual friend of ours :-)

Dhwanil said...

Hi Niraj,

I completely agree with some of your observations. In hindsight, I have realized that we succumb to such biases instinctively due to conditioning that we have developed. I enjoyed reading the post.

Neeraj Marathe said...

Thnx Dhwanil,
Glad to learn that u enjoyed reading it..

JM said...

Dear Professor Neeraj,

Now that you have become famous I hope you will not describe us so much clearly about our biases.

OMG I suffer from bad management bias and so missed OC completely though it has a monopoly in Insoluble sulfur.

Best wishes,


Anonymous said...

Decision bias (similar to liking / dislike bias) - Since I analysed it earlier and reached a decision of it being not good, I continue to see it as not good or vice-versa.