Finding the Inefficiencies

odd one out pencilThe proliferation of passive investment strategies over the last 20 years underscores the common belief that markets are rational and efficient. That belief has led to an ongoing debate about the effectiveness of active versus passive management: If markets are efficient, as Modern Portfolio Theory posits, how can active managers add value?

But are markets truly efficient? Markets have been historically ineffective in identifying change in market conditions, and in correctly gauging the extent and magnitude of the effects of those changes. Additionally, the investors who comprise those markets are human and, as such, are subject to human biases in decision-making. Thus, active portfolio managers can indeed add value by exploiting these inherent market inefficiencies.

Investing in companies that display accelerating earnings growth has been shown to add alpha over time. Markets have been historically slow to identify inflection points that signal a change in a company’s performance—the earlier they can be identified and evaluated, the more rewarding it can be for investors. In their 2010 paper “Does Earnings Acceleration Convey Information?”, Cao, Myers and Sougiannis substantiate the link between earnings acceleration and asset price movement, concluding that the actual level of growth not only is relevant, but that the trend of growth is meaningful in its own right.

Earnings acceleration is often mistimed or underappreciated by the market. While research and conventional wisdom suggest that analysts incorporate their effects into future performance of a stock, consensus estimates often fail to capture the magnitude and duration of the earnings acceleration trend. This creates a lag between investor perception and action that active managers can exploit.

Active managers, however, must overcome potential human behavioural biases that support market inefficiencies. One such bias is availability—or conventional wisdom—that leads investors to adhere to widely held beliefs, despite empirical evidence to the contrary.

Another bias—anchoring—sees investors using the latest data point as a starting point for analysis. This would mean, for example, focusing on current stock price or earnings per share levels, rather than using fundamental analysis to determine inherent value or looking for potential game changers that could materially transform the calculations.

Risk aversion bias causes investors to make emotional, rather than rational, decisions about risk, which can lead to incorrectly estimating the effects of change. It leads directly to the herd effect, which holds that, once the company’s story is widely known and acknowledged, investors will pile on the bandwagon, afraid to miss out on the run.

All these biases can come into play at the top of the S curve, which is the top of a curve showing the earnings growth rate of a hypothetical company. The line demonstrates a decline and inflection point that occurs when the rate bottoms and turns positive, and the rapid, exponential increase before another inflection point when it peaks and begins to decline. In such cases, investors are holding on to the current trend for too long, despite clear evidence of changes in fundamentals.

Active managers add value by focusing on change and inflections in company fundamentals. Using a solid fundamental process to identify such change can help to avoid some of the inherent biases and inefficiencies in markets that have led to the popularity of passive strategies.

Bernard Chua is Vice-President, Client Portfolio Manager, American Century Investments