Over/Underreaction
This week we discuss investor biases, retail flows into the stock market, and techniques on how to evaluate people.
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This past week, I caught myself staring at my screen in disbelief as one of our holdings, TaskUs, fell 25% within 20 minutes of the market opening. TaskUs had just reported earnings the day before and while it beat most key metrics, it provided lighter than expected revenue guidance for 2023. However, a 25% decline in the stock price made no sense to me for a growing, profitable, mildly-levered company trading at less than 13x earnings. So, I ended up buying more stock at what luckily was the day’s bottom. The stock subsequently rallied 21% intra-day, and again ~5% the following day once the broker reports came out reaffirming ratings and a meaty price target (at least compared to the current price).
Now it was clear to me that, at least in the short-term, this price action was a complete overreaction. The question I wanted to explore for this post was why these overreactions happen. My initial reflection brought me back to a lecture I attended at my alma mater by Richard Thaler – one of the godfathers of behavioral economics. He was discussing the core part of this research which implies that an integral part of economic theory is flawed because it assumes that humans are rational. We all know from our daily lives that this is certainly not true. In his own words Thaler says, “the crazy thing is thinking humans act logically all the time.” This illogical nature of humans, according to Thaler, extends to the stock market where investors regularly either overreact or underreact to financial news. His research has resulted in the launch of several mutual funds that have had a strong track record.
To judge why the over/under reaction happens, we need to understand the underlying biases that drive them. The first error in judgement is caused by a recency bias. We tend to think what happened most recently will keep happening. In the stock market context, we think winners will keep winning and losers will keep losing. This causes overreaction. Thaler actually proved this in a 1985 paper where they tracked the 35 best (“winners”) and worst (“losers”) performing stocks trading on the NYSE that year. In subsequent years, it turned out that the “losers” portfolio consistently beat the market whereas the “winners” did the opposite – and after about three years the “losers” became the ”winners” and vice-versa. Here, we clearly see the overreaction at play. The ‘bad’ news that caused the ‘losers’ to underperform caused an overreaction by investors who overtime saw that the future of those businesses was actually not too bad, and bid them back up. Similarly, the “good” news that drove the “winners” to do well was eventually discounted by investors when they realized they had overreacted to it.
There is also a strong element of availability bias here, which is the tendency for humans to rely on information that comes readily to mind when evaluating situations or making decisions. In the TaskUs case, all market participants could seem to focus on was the FY23 revenue guidance and in those initial minutes of market opening, overreacted to that data point.
Overreaction is not the only issue – its opposite, underreaction causes several investing mistakes. It was hinted to me the other day that I was underreacting to the disruption threat of AI. My point was that the “AI” disruption threat is such a blanket statement that it's used as a cudgel against almost any bull case. Own a BPO – AI will disrupt it. Own any sort of service firm – AI will do the job better. Own a SAAS company? AI will create a program much better than yours and sell it much cheaper. You’re an artist? HA! AI is more talented than you. So, in my view the AI disruption threat gets stretched a bit too far.
But what if I’m wrong and I’m underreacting to this threat – and it’s like a frog in a slowly boiling pot. What if initially it is used for low-value work like chatbots and cheating on university assignments, but then it starts to replace several key business models and jobs. Would some of our portfolio companies be at risk? Certainly. Underreaction to disruption has killed several once famous businesses. Kodak, Blockbuster, Polaroid, Toys R Us, etc. The interesting element here is that their declines happened slowly and then all at once – making underreaction almost more dangerous than its over-counterpart.
The onset of the pandemic I think also showed strong signs of underreaction. Before the proverbial sh*t hit the fan in March 2020, we had for at least one month seen the lockdowns happening in China. Despite this, global markets, as a whole, did nothing. In fact, the first two months of 2020 were decent returns-wise. The market just underreacted to the most impactful event of our lifetimes (move along, 2008 GFC) when the evidence of its damaging effers was right in front of us. Wuhan had been locked down for several weeks by then. It wasn’t until global lockdowns occurred did markets wake up, but by that point it was pure panic. The ending of the pandemic also caused an underreaction as the market was too slow to see the effects of rising inflation, partially lulled by the Fed’s transitory terminology.
It'll be interesting to see what risks we over/underreacted to when 2023 ends. My thinking is that we’ve gone from underreacting to inflation to overreacting to it, especially as we lap high comparisons from previous years. But we’re probably underreacting to the effect of sustained high interest rates given how well the ARK funds have done this year and the fact that Bitcoin is up 40%. What is clear to me is that the market is still quite macro-driven, so this year will present many instances of over/under reaction that can be taken advantage of.
Thanks for reading and happy investing.
Farrer Fun Fact
Retail involvement: I saw this chart circulating a few weeks ago. Most took it as a bearish sign, typically when retail gets heavily involved in markets its a sign of a top. But what I though was more fascinating was the level jump from pre to post-pandemic (a difference of a billion dollars daily). It seems like elevated levels of retail involvement in the stock market are here to stay.
Articles and Videos of the Week
I can’t say I agree with this entire list - but this was probably the most thought provoking post I have read recently - 8 Techniques for Evaluating Character. Its useful for trying to evaluate management/employees/investors.
“Uncommon Facts about Alphabet’s Common Stock” - this was an excellent bull thesis on Google (not investment advice).
After Hindenburg’s Adani short report - NYU’s Damodaran posted what I thought was a rational summary of the short thesis and why it may not be all that earth-shattering.
This was a fascinating thread on why banks fail.
Looking for some light reading? Here is a comprehensive list of investing books.