With so much information available to investors today, you might think that markets have become more rational. Think again. Equity markets are as emotional as ever—and maybe even more so. In a short-tempered world, we believe patience and human judgment are more important than ever.
Equity investors today face an unprecedented flood of information. Newswire services pump thousands of headlines into the markets each day, while millions of tweets and social media posts add to the din.
Yet the deluge of data hasn’t made markets more efficient. Our research shows that US stocks have been reacting more sharply to earnings surprises since 2000 than they did in the previous 14 years (Display). Even with high-frequency trading machines working frantically to capture every possible opportunity by the millisecond, behavioral biases have actually intensified. And dislocations caused by reactions to unexpected market news often last for months—just as they did in the past.
Is there a way to overcome the information overload? In our view, a classic value investing approach is well suited to exploiting the short attention span of the digital age. Value investors look for companies that have been hit by an overreaction to bad news, in an effort to identify stocks whose recovery potential is being overlooked. It’s a discipline that relies on research to cut through the information fog in order to focus on fundamental drivers of earnings and returns.
Framework for Value Investing
Every controversy will vary according to a company’s specific circumstances, industry dynamics and surrounding events. However, there are some common scenarios that define value opportunities today and haven’t really changed much over time. We frame the value investor’s mission with three simple questions (Display).
ill Earnings Recover?
This question is especially common in asset-intensive cyclical industries. In a successful industry, companies tend to build too many factories or open too many stores or spend too much capital, which can lead to overcapacity. Eventually, demand usually catches up. When the industry news is downbeat, it can be very hard to determine which companies are best positioned for a rebound.
Restructuring stories create a similar dilemma. When management launches a new strategy, involving cost cuts, plant shutdowns or asset sales, markets are often skeptical and don’t really believe the restructuring plan will work. Investors who defy pessimistic headlines to identify successful turnaround stories are usually rewarded handsomely.
Can Earnings Be Sustained?
Technological or regulatory disruption also generates controversy. Equity markets are littered with the carcasses of companies that failed to adapt to evolving circumstances—like Eastman Kodak or Pan American World Airways. Yet because these failures are so dramatic, investors often project their worst fears on companies that are capable of adapting. And companies that manage to sustain earnings and thrive in a rapidly changing world tend to deliver outsize returns.
Sometimes an industry challenge or competitive threat can jeopardize an established business model—and obscure a long-term opportunity. In other cases, the mispricing of a company’s assets—whether physical or intangible—may create pressure to adapt and raise questions about the sustainability of earnings.
Is Management Able to Fix the Problem?
Financial stress is another key controversy. When a company has taken on too much debt, anxious investors may push the shares down. Value investors’ keen focus on cash flows helps them determine whether management is up to the job of restructuring a balance sheet and steering a course back to success.
Abundant cash flows also raise questions about management. Investors must assess whether free cash flows will be applied properly to determine whether shareholders are likely to be rewarded for their fortitude.
These three questions have one thing in common: they all require research insight and human judgment in order to be answered with clarity in a world of abundant information. Finding cheap investment candidates with significant recovery potential requires experience, historical perspective and the patience to look at a company in controversy and develop conviction that a different future is possible.
This blog was originally published in InstitutionalInvestor.com
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.