Update No. 72 – 10/08/12

There are a variety of cognitive biases a successful investor must overcome.  A great many of these biases are inherent in your thinking, every person is predisposed more to some than others.  Further, I believe everyone is somewhat cognisant that biases exist (even within themselves), but have a look through this extensive Wikipedia list of cognitive biases, if you stop and think about them all, I think you’d be surprised how often you’ve fallen victim to a variety of the biases on the list, usually unknowingly.

Of all the reading I’ve done about models of thinking, the most valuable has come from Charlie Munger.  He has never written a book or collated his thoughts in any formal way, but Poor Charlies Almanack is perhaps the most useful book I’ve ever encountered on the way we can think to be successful.  For those of you who can’t buy the book, here is a speech Munger gave in 1994, which gives a fairly concise (less than 14,000 words) discussion chiefly directed at how successful people think.  Simply having a good awareness of the biases that exist is an outstanding start.

One example where a cognitive bias might exist for investors is in the area of ‘Share Buybacks’ or repurchases.  I came across this report by Credit Suisse a few weeks back about the use of buybacks within the S&P500 (major US stocks).  The cognitive bias most at play in this situation for an investor, in my view, is Confirmation Bias, because the Board has decided to repurchase the company’s stock, it ‘confirms’ our assessment that the stock is undervalued.  In fact, the study indicates that of the companies that repurchased stock over the 7 years examined, only 36% beat the benchmark (the S&P500 of which they were part) in respect of the return generated.  The benchmark return over that period was 4.1% per annum, so it wasn’t exactly a difficult hurdle.  More to the point, it seems 64% of companies conducting buybacks were effectively harming their shareholders.  Statistically, it should be likely that these numbers should be closer to 50%, but it seems a company is more likely to repurchase its stock when it is overvalued (relative to the market).  Observe within the report that repurchases within ‘finance’ stocks in the 2005/6/7 years amounted to $245.22 billion and within the 2008/9/10 period (when financial stocks were generally very cheap and many were quite clearly undervalued – with a few notable exceptions) only $57.17 billion of repurchases were made.  I have commented on this before, but it staggers me how poor many executives are in making assessments of the value of the businesses they run, given their inherent informational advantage.  For companies in the financial industry, the GFC presented what was probably a once or twice in a lifetime opportunity to really enhance the returns for those shareholders who had the faith to stick with them and as a group, they blew it terribly.

I confess that I can’t recall a situation where I have been upset that a stock I have owned has announced a buyback, primarily because of confirmation bias.  I usually also find myself similarly pleased when a director or executive makes meaningful on-market purchases, and find it equally troubling when I see executive/director sales.  Share prices often spike after a buyback announcement and based on this research, would often seem to present a good opportunity to sell into this news…

I point this out as a way of using research to overcome a likely bias, in future, when a stock I own announces a buyback, I will force myself to critically review my reasons for holding an ownership in that business.  I confess I am in the habit of making such critical reviews of businesses we own at least quarterly anyway, but I will use the excuse of the possible existence of confirmation bias to force myself to be even more vigilant with such a review.

Speaking of reviews, it is ‘profit season’ here in Australia, the market ran well on a few positive leads this week and we failed to keep pace.  We have 10 holdings in EGP Fund No. 1 Pty Ltd, two report in the coming week, 1 the week after & 5 in the last week of August, so depending on results, it could be a bouncy time (hopefully bouncy ‘up’, as the market recognises that which we already know of our holdings – but you never know with the market…).  Our 10^th holding has a Feb/August cycle & thus reports toward the end of November.  I will provide some commentary on how results went relative to my expectations over the next couple of weeks – Tony Hansen 10/08/12.

*Unaudited figure to be confirmed externally

EGP Fund No. 1 Pty Ltd. Up by 5.59%, leading the benchmark by 1.11% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 8.75%, leading the benchmark by 15.2% all-time (April 1^st 2011).