Sometimes stocks behave badly – how should investment managers react?
For big top-down asset allocation decisions, managers are shielded by collective responsibility. The pain is shared across the team. But a disastrous stock performance is felt very personally – both for the recommending analyst and portfolio manager.
This year, despite upward trending markets, some share prices have collapsed on bad news. Provident Financial, Dixons Carphone and WPP are three FTSE 100 stocks that have hit portfolios this year. So how should managers react?
For small and mid cap stocks, volatility goes with the territory. And, if dealing is difficult, the decision may already be made for managers; selling in the short term may not be an option. It may even be hard to buy, in order to average out.
In the short term, true price discovery is difficult. But, that may not be what clients are told, as there might be more attractive stories than inertia and illiquidity.
Investment reports when a holding is retained may talk of ‘conviction’, ‘management meetings’, ‘value’, ‘market overreaction’ and ‘long-term fundamentals’. Unfortunately, investment teams often come to believe these narratives themselves.
Companies have their own stories, too. ‘Soft patch’, ‘back-end loaded’, ‘investing in price’ and ‘business transformation’ all help sweeten disappointing news.
Profits can be adjusted to show what the management think are the true ‘underlying’ trends. And even a complete change in strategy can be glossed over as ‘a pivot’. Company CEOs and boards might be suffering as much shock as their investors – self-protection often prevails over candour.
The root of the problem
Company updates that trigger these falls may be the first sign of serious disruption to a long-established business model. FTSE 100 companies earn their blue chip status by a long process of building moats around their business, which protects margins by unique structural advantage, intellectual property and scale. But that may only buy time, as new entrants with radically different business models challenge incumbents.
The halo effect around these big companies and sophisticated narratives, can disguise crumbling foundations. The profit warning itself might fudge the underlying issues; analysts and managers need to get to the root of the problem quickly.
Some businesses genuinely do have underlying strengths. Berendsen, for example, fell 41% but fully recovered on a bid. Time will tell whether other mid caps such as Kingfisher, Indivior and Hikma can bounce back. Changing strategy and management could take years, and waiting for a bid might take forever.
Humans typically respond to mistakes with denial, use of context, asserting good motives, and claims that an issue is the exception. Only denial - playing down impact – is always a bad response. Mistakes can happen and should be assessed against the totality of a manager’s work and whole portfolio.
Asserting that a rebound must happen can be a form of denial that the fall has actually taken place – ‘it is not a loss if you don’t sell’. Clients in funds that are marked to market are sceptical on that one.
Rational decision-making is difficult after a profit warning and share price collapse. For most investment professionals it is a body blow, injuring pride even if a stock is a small percentage of a portfolio.
It is too easy to focus on that one stock in isolation, rather than in the overall context of total portfolio returns and the long term. Headlines give salience and demand undue attention.
Managers feel they must create a narrative for the stock and company update, reasserting their control over the situation with talk of ‘renewed confidence’.
With some, self-belief is so strong that the construct almost becomes an alternative reality, in which the price collapse has not actually happened. Buying more stock ups the ante, and engages emotionally with the sellers.
Academic studies have analysed the behaviour of persistently under-performing managers. These can include shifts in risk appetite, confirmation bias and lowering levels of engagement with colleagues. But reaction to bad updates on individual stocks is a very different challenge, with its own characteristic behaviour.
Managers achieve prominence by their education, intellect and ability to articulate – skills often linked with motivated reasoning and illusory confidence. It can be hard for clients to spot these signs amid the positive attributes they identified in managers in the first place. Denial and emotional language may be the most helpful signals.