Three behavioural biases

Around this time last year I remember starting to think that investors in general, especially those in the equity market, were becoming overly bearish. Markets had already fallen a fair amount from their peak. Equity valuations did not look hugely stretched, at least not on some measures (see below). Meanwhile, the press and all the talk seemed to be very negative. For sure, some of the bears made valid points, such as analyst estimates being way too high, and the still highly inflated prices in other risk assets such as commodities and real estate. But, for equities in particular, I couldn't help thinking that a lot of this was now priced into the markets. Of course, subsequent events, which saw equity markets in developed economies fall at least another 30%, suggested that my view was clearly wrong, or at best far too early.

Of course at the time it was not clear that the financial markets were about to almost completely collapse. Even the uber-bears were not predicting this. So I think it would be unfair to say that the subsequent path of equity markets proves that my belief this time last year was wrong. That said, I am somewhat disappointed with myself for not being able to truly see the wood from the trees. That equity markets have fallen way further than I thought they would when I initially turned positive suggests that I had at least not aqequately assessed the risks involved.

So why did I fail to assess the risks properly? Having put considerable thought to this question, I have come to the conclusion that it can mostly be explained by behavioural finance biases, rather than a specific informational or interpretative deficiency. Indeed, I think the only information gap was my lack of understanding of the banks' and non-bank financial institutions' balance sheets. However, virtually all investors were in this camp given the poor levels of disclosure. Behaviourally speaking, I woulld highlight three biases that I think adversely affected my assessment of the situation:

1) Familiarity bias. This is the tendency to draw heavily on facts that one is familiar is. Being an equity investor and not a credit investor, I tended to look closely at equity market valuations, and especially those in the sector that I was a research analyst for at the time. I did not think these valuations were hugely stretched given how far many of the stocks I was interested in had already fallen. Therefore I conlcuded that it would be very unlikely for these stocks to fall a great deal more given what the market had already priced in. The mistake I made was to apply this to the whole equity market, failing to appreciate fully that a lot of other sectors such as mining (well at least I knew that was overvalued!), industrials and other financials were not yet pricing in the same sort of outcomes. I also rather naively assumed that the outcome being implied by the credit markets should not be taken too seriously given the huge liquidity dislocation within those markets.

2) Extrapolation bias (I think this one may actually have another name, but it is obvious what it means). Here I think the mistake I made was relying too much on one indicator - the earnings yield versus the bond yield - to draw a bullish conclusion. This measure which has worked reasonable well for the last 20-25 years or so suggested equities were very cheap compared with bonds, even after adjusting the earnings down 15-20%. I knew that other measures such as cyclically adjusted p/e ratios and tobin's q still suggested the market was slightly expensive on an absolute basis, but I also knew that historically these measures have not been great buy and sell indicators in the near/medium term (i.e. 1-2 years). Perhaps I should follow Jeremy Grantham and rely more on mean reversion for my investment decisions in the future.

3) Overconfidence. Here I think my mistake was not to fully appreciate how serious the "known unknowns" could be, in particular the scale of the exposure on bank balance sheets and the knock-on effects this could have. For sure, I was aware of the problem, I knew it was one of solvency and not liquidity, and I also suspected that more capital might need to be injected at some point. But I was overconfident (naive?) to think that this was already reflected in the general level of equity prices. One of the tests that behavioural finance researches routinely run is to ask people to estimate on the spot with 90% probability (90% confidence interval) a range of answers for a specific question, such as the 150 year total return of US equities. The results usually show that respondents vastly overestimate their ability (i.e. way more that 10% of respondents' range estimates are outside of the answer). I guess if you had asked me to estimate a 90% range for the market this time last year, where we ended up would have been outside of my range.

Laird looking promising

Encouraging results from Laird yesterday. It sounds like they have not seen any further deterioration in their end markets since the profit warning back in November. The handset business (55% of sales) is tracking down slightly more than 10% in volume terms, roughly in line with the OEM handset market. The CFO produced an interesting slide, showing just how far away they actually are from their debt covenants. Adjusting for the currency mismatch between the balance sheet reporting date and the average rate used for the EBITDA suggests they can see a £60m fall in their EBITDA before hitting their covenant. So the current £100m of EBITDA is 250% above the floor. The main risk is pricing, especially in handsets. Their key customers are Nokia, Samsung, Mororola etc., all of whom are facing double digit declines in their end markets. If the overcapacity in the handset market is not corrected quickly enough, Laird’s gross margin (currently, c20-25% in handsets) could get hit. A lot of costs have already been taken out, so the hit to profit if there is another big leg down in trading could be severe. Against this, Nokia has no interest in busting one of their major suppliers, and it also sounds like a lot of Laird’s (unlisted) competitors are in even more trouble that they are.

These shares have fallen over 85% now from their peak. Even after yesterday’s move in the share price, they are trading on just over 4X 7-year average trailing p/e (4.3X on next year’s consensus estimates), and around 30% of reported 2008 book value. If you are prepared to accept that trading is not going to be so bad that the covenants are hit, then the market is basically saying Laird is an ex-growth, low return on capital business. The historical 7 year median CFROI has been over 15%, and the return on capital is over 10%. For sure returns are unlikely to return to their historic level, but it certainly seems like there is a decent margin of safety to the Laird shares. If I put all the intangible assets (mostly acquisitions) and the PPE and inventory at 50% of reported value, then the adjusted book value per share is 100p, 20% up from today’s 80p.