"We firmly believe that a consistent combination of value, growth and sentiment is the key to good investment results." - Brian Bruce, Hillcrest Asset Management
[Behavioral finance in the financial services industry has been very widely discussed, seriously explored and, finally, now starting to be implemented into financial advisor business models and client engagement practices. But less mainstream industry awareness and traction exists in its application to financial analysts, asset managers and the investment process itself – behavioral finance as the basis of an investment methodology.
The study of the influence of psychology on the behavior of financial analysts and investment managers demonstrates that they are also influenced by their own biases. Substantial research further proves their behavior can have subsequent effects and influence market reactions.
This area of behavioral research and disciplined implementation has been the realm of new Institute member Brian Bruce, CEO of Hillcrest Asset Management, with his decades of research work spawning The Journal of Behavioral Finance, a vibrant investment professional community, and a full-fledged behavioral investment methodology embodied in a series of Hillcrest Small Cap and Mid Cap strategies. To get a better understanding of this area and its growing recognition and place in the investment landscape, the Institute reached out to discuss this topic further. Come explore this area with us.]
Hortz: What is the basis and core philosophy behind a behavioral finance methodology to investing?
Bruce: Behavior is important because it is the reason that active management works. The accepted theory on asset pricing is the Efficient Market Hypothesis. It says all information is in the price of a stock. It’s why so many people index. What the theory neglects is the mechanism that the information takes to get into the price. Information comes from the company or news outlets and goes to analysts and investors. They then have to make a buy, sell or hold decision about the stock based on that information. The buying and selling are what moves the price. The key from a behavioral standpoint is that a decision must occur. That means the price is not only based on the information but also on the behavioral and cognitive biases that occur when that decision is made.
Our investment philosophy at Hillcrest is firmly rooted in our expertise in Behavioral Finance. We believe stocks deviate from their fair value due to behavioral biases that occur among market participants. Deviations from fair value follow a systematic pattern we call the Behavioral Cycle. Understanding this Cycle and the behavioral pricing dynamic associated with it allows us to capture pricing inefficiencies created by market biases. We believe that a consistent and repeatable pattern of outperformance is achieved by combining the techniques and insights of traditional analysis with sentiment indicators we specifically developed that isolate these Behavioral Finance issues. Biases such as expert overconfidence, recency effect, framing, and the base-rate effect, as examples, are common traps for active managers and behavioral approaches can offer a better way to determine stock valuations and future growth prospects.
Besides just acknowledging behavioral factors, a behavioral finance investment methodology works to systematically uncover and take advantage of or defend from these pricing effects to maximize alpha and reduce risk. Two of our portfolio managers, Douglas Stark and myself, built the first global behavioral model in 1991 when we worked together at an institutional money manager to determine analyst sentiment. We continue to be thought leaders in the development of behavioral sentiment models. We feel the accurate analysis of sentiment can make or break an investment strategy.
Hortz: You co-authored back in 2004 “Analysts, Lies & Statistics: Cutting through the Hype in Corporate Earnings Announcements” - the first book on analyst behavior and a comprehensive guide to interpreting corporate earnings announcements, revisions and surprises. What have you been uncovering in your research?
Bruce: “Analysts, Lies & Statistics” (ALS) explored the cycle of information flow between companies, analysts and investors to more deeply understand earnings revision and earnings surprises. The research uncovered that financial managers and analysts mediate corporate earnings announcements and the conflicts of interests that can affect the release of corporate information.
Our research showed that company management changed their behavior when they realized that institutional investors were comparing their forecasts to actual results. Management went from overstating the future earnings to understating them in order to create a positive earnings surprise. These were the first behavioral concepts applied in money management. ALS became required reading from institutional researchers to mainstream investors on how to better interpret and use earnings estimate data.
Since then, we developed a proprietary analysis process to determine the sentiment of the management team of each company we review. Determining the sentiment of investors outside the company is an important challenge, but just as important is the more elusive sentiment within the company. That led us to study earnings call transcripts creating a proprietary scoring system to compare the number of positive phrases to negative phases. Companies where the executives are nervous, apprehensive or concerned, or trending so, have increasingly used more negative phrases.
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 Likeihood factor quantifies the reliabilty 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.
We also incorporate an in-depth qualitative process to further analyze companies using data that are hard to quantify, or that are company and sector specific. Our expertise in behavioral finance gives us a unique competitive advantage during this qualitative fundamental analysis. Analysts also often succumb to behavioral errors such as: falling in love with certain stocks, aversion to selling losing positions and style creep. We have developed processes and methodologies to avoid these behavioral flaws.
In constructing portfolios, we avoid behavioral flaws by using current information, not past statistical relationships, i.e., portfolio optimizers. Hillcrest neutralizes non-alpha factors by only taking significant deviations relative to the benchmark on stock-specific factors like value, growth and, most important, sentiment. Our strategy and methodology we believe create numerous advantages over our competition.
Hortz: What are you seeing as to trends on applying behavioral finance as an investment methodology? Do you have any concerns?
Bruce: Every year more people express interest in adding a behavioral component to their investment process. I’ve heard recently from two mutual fund firms who want to add a behavioral manager to their platform.Our main concern is that many active managers now mention behavior as part of their process, however there are only a handful that utilize behavior in all parts of their investment process like we do.
Behavioral insights should not just be given lip service or applied casually or one dimensionally. They are not just a series of models but an approach to investing that starts with philosophy, permeates stock selection and continues all the way through portfolio construction. A true behavioral finance firm follows the philosophy of behavior in every part of the investment process.
Hortz: Any final comments or recommendations you want to share with readers on furthering their inquiry of behavioral finance as an investment methodology?
Bruce: Behavior is important because it will last longer than investment fads or trends. It’s based on cognitive biases that never change. It is programmed into our brains from thousands of years of evolution that drives our actions. Investment performance we feel is anchored in the ultimate inseparability of investor (mis)behavior that our process captures from the market itself, serving to ensure the process we utilize will not permanently lose efficacy.
These are biases a good behavioral investment manager is fully aware of and can take advantage of. We firmly believe that a consistent combination of value, growth and sentiment is the key to good investment results. Behavioral investment methodologies formalize and chart a course of systematic, repeatable, model-driven, non-emotional action that takes advantage of this built-in irrationality in the markets to create alpha and protect against risk.
The Institute for Innovation Development is an educational and business development catalyst for growth-oriented financial advisors and financial services firms determined to lead their businesses in an operating environment of accelerating business and cultural change. We position our members with the necessary ongoing innovation resources and best practices to drive and facilitate their next-generation growth, differentiation and unique community engagement strategies. The institute was launched with the support and foresight of our founding sponsors - Pershing, Voya Financial, Ultimus Fund Solutions, Fidelity, and Charter Financial Publishing (publisher of Financial Advisor and Private Wealth magazines). For more information click here.