Investor and Relational Risk Management
In the last post we talked about how sometimes investors are rational but still need time to react, while other times they overreact because of various forms of bias, delay, mania or other market inefficiencies or feedback loops. We illustrated this using the hidden intrinsic value and saw the reaction as this value jumped up and down.
But is it unrealistic to expect the intrinsic value to jump like that? Is it a more gradual change instead maybe, causing these investor reactions to become insignificant with regards to their difference?
It’s not at all unreasonable to assume that the value of a company typically grows or shrinks gradually. It takes time to close deals, manage production, and build upon these. Sure, sometimes, like we’ve seen recently with companies like Stamps.com which dropped from around $198 to around $90 last Friday, or a similar dramatic drop in Kraft Heinz, we do observe dramatic changes in even big companies.
But more likely we don’t. So what happens then to investor reactions if we have gradual changes? Building on the illustration from the last post, we’re here showing a gradual change in the hidden intrinsic value. Again we have a red and blue reaction, with the red reaction being more excited than the blue.
What is clear is that even if there is a gradual change in the hidden intrinsic value of a company, investor reaction is always lagging. We explain this by pointing towards the required processing needed to observe, distill and react to any new information.
It is our view that investors reaction and behavior in the stock market represents a certain type of risk, but also an opportunity. As any action by any market participant will have an impact, as it changes supply and demand dynamics of the market, this action is measurable.
We measure this using clever analytical techniques and present it as a company rank value, which is relative to the other companies we monitor.
If a company is ranked too highly, there’s a risk that investors have overreacted, expecting too much future growth. This can cause future disappointments, with a related decline in relative performance. This typically applies to the top 10 companies on our ranking list. We therefore recommend avoiding these companies in your portfolio, or at the very least tighten your risk management of these.
Moving down the list, it might be that a company is doing well and we see an opportunity for further growth based on current investor behavior. These are companies that rank well, but are not part of the first few. This is what we call “the next 10”, and a portfolio of these 10 companies tend to outperform the top 10 companies on our ranking list. This can all be confirmed by exploring our different portfolios on the portfolio page.