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Taking Advantage of Behavioural Finance – The Market Mogul

What is the usual response if a company releases results that fall below expectations? It is usually a significant drop in share price. This is because of the phenomenon that is called behavioural finance. Investopedia defines behavioural finance as:

“a relatively new field that seeks to combine behavioural and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions.” tweet

There are many variations of behavioural finance, with the particular instance I discussed above attributing predominantly to herding and/or overreaction.

Overreaction is fairly self-explanatory and draws on the theory of investors overreacting after a negative announcement. I believe that investors who fall under this category are responsible for the next one, herding. Herding, or herd behaviour, describes the tendency for investors to feel pressurised and thus copy large groups of other investors. The investors who have overreacted often form these large groups, hence why I’m holding them accountable.

It is this that is partly responsible for stock market bubbles forming, which has occurred many times throughout history. The most famous of these is of course the dotcom bubble, however, economic bubbles have been an issue for centuries, such as the time when, amazingly, the price of a single tulip bulb was selling for more than 10 times the annual income of a skilled craftsman back in the 17th century. Value investors will try and estimate a company’s intrinsic value via various analyses and valuation models, particularly multi-period models such as discounted cash flow, and if their valuation is above the current share price they will buy. Value investors also tend to focus on stable, long-term investments as well.

Now, take the concept of a value investor purchasing shares in a company after performing all relevant analyses and valuations and in turn believes the company is undervalued. If the quarterly results aren’t as good as was predicted, this will likely see a significant drop in the share price due to reasons discussed above. Rather than this particular investor panicking, what they should actually do is see it as a profit-making opportunity. This is because the same company they believed is undervalued prior to the quarterly announcement is now selling for an even cheaper amount. Providing they are confident with their valuation and believe the company should be selling for a higher amount, it should highlight the time to purchase even more of the shares, as they’re confident it will rise in the long-term. This is something that Christopher H. Browne discusses in detail in his book, The Little Book of Valuation, and in particular within Chapter 1, ‘Buy Stocks like Steaks…On Sale’.

It is also worth noting that the sudden and significant price drops/rises occurring as a result of overreaction are often not permanent, with the mispricing eroding over time to reach back to its equilibrium.

Empirical Evidence

As an extreme case of being able to make a profit in these circumstances one could look back at the share price of Rightmove, the online real estate portal, which bottomed out at a price of 160p in January 2009 as a result of the financial crisis. If, as a result of you believing it was grossly undervalued and that Rightmove will hang on throughout the crisis and flourish thereafter you bought more shares at this low of 160p, you would have made a capital gain of over 2300%. This assumption of the company hanging on through the crisis was arguably rational due to its dominance in its industry where it held 80% of the market share.

Observing a more common scenario, we can look at the FTSE 100 company, Imperial Tobacco. On the 19th August 2015 they released an Interim Management Statement for their 3rd quarter, which showed they were on track for their full year results. Nevertheless, the news was strangely greeted with a surprising initial drop of 4.62% in share price. Along with a further 5.09% drop as a result of a notification of transactions of Directors and PDMRs, the share price has not only risen back to what it was on August 19th, it has risen a further 3.5%.

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Taking Advantage of Behavioural Finance – The Market Mogul}

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