Most investors I know – and I reckon, most investors out there too – check the prices of stocks often before they make any buy-or-sell decisions. It seems innocuous enough, but, that act of checking alone can result in a biased investing view. In a study, researchers found that experts valued a home higher if the seller had listed the property at a higher selling price. As Adam Grant, a psychology professor at Wharton, wrote in a recent op-ed: “After inspecting a house, real estate agents thought it was $14,000 more valuable when the seller listed it at $149,000…
Most investors I know – and I reckon, most investors out there too – check the prices of stocks often before they make any buy-or-sell decisions. It seems innocuous enough, but, that act of checking alone can result in a biased investing view.
In a study, researchers found that experts valued a home higher if the seller had listed the property at a higher selling price. As Adam Grant, a psychology professor at Wharton, wrote in a recent op-ed:
“After inspecting a house, real estate agents thought it was $14,000 more valuable when the seller listed it at $149,000 than $119,900.”
In other words, the existing price of the property had acted as a biasing factor for the experts who were valuing it. The same kind of effects may be prevalent in investing too. That’s why putting the study of the business and an evaluation of its value first may result in better investing decisions.
The value of not looking at stock prices
Al Gore is perhaps best-known as a former U.S. vice president. But, Gore’s also the co-founder of a highly successful global investment firm called Generation Investment Management.
In the decade ended June 2015, Generation had achieved returns of 12.1% per year, far ahead of the 7% annual gain clocked by the MSCI World Index, a measure of worldwide stock market returns.
In a profile of Generation by The Atlantic, there’s a description of the firm’s investing process. Generation holds “focus list” meetings whereby the business and management quality of potential investing opportunities are discussed. Companies that pass the mark are then placed in the ‘focus list,’ a list of stocks that Generation will buy when prices become attractive.
What’s interesting here is that a company’s stock price is not mentioned in Generation’s ‘focus list’ discussions. While there are many factors that come together to explain Generation’s market-beating results, I think that the firm’s process of actively reducing the opportunities for the stock’s price to bias any investing decisions has an important role to play.
What if there’s no choice?
But what if an investor comes into daily contact with live stock market prices? How else might he or she remain insulated from the biasing effects of prices? One way to do so would be to value a company backwards.
Stocks are often valued based on the growth they might achieve. Investors input estimated future growth rates into their models which then spit out a price. But, there’s another way – and that is to look at valuing companies in reverse. Instead of trying to estimate growth in the years ahead, we can use reverse-engineered models to calculate what growth is currently implied in the stock’s price.
With the implied growth rates, investors can then use their judgement to see if the numbers make sense. James Montier, a member of the asset allocation team at the highly successful investing firm GMO, explains the benefits of reverse-engineered valuation models in his book Value Investing: Tools and Techniques for Intelligent Investment (emphases mine):
“When I am teaching on behavioural bias, I often use the reverse-engineered DCF [discounted cash flow] approach as an example of avoiding the common pitfall of anchoring in the context of valuation.
All too often, I have seen analysts return from company meetings raving about the management and working themselves into a lather over the buying opportunity this stock represents. They then proceed to create a DCF that fulfils the requirements of a buy recommendation… They have effectively become anchored to the current price.
When a reverse-engineered DCF is deployed this obsession with the current price is removed, as the discussion now takes place in terms of growth potential.”
My colleague Stanley Lim has shown how a reverse dividend discount model (another type of valuation model) can be applied to various real estate investment trusts and business trusts listed in Singapore. One such example is CapitaLand Retail China Trust (SGX: AU8U).
Back in 5 October 2015, the China retail mall-focused real estate investment trust closed at S$1.41. Through a reverse-engineered dividend model, Stanley found that the REIT had an implied growth rate of 1.14% in its distributions at that price over the long-term future. From there, investors can then judge if that growth rate looks reasonable or not.
A Fool’s take
The act of not looking at stock prices when studying an investing opportunity can be helpful in improving our investing decision making. But, if a daily bath in price-related information is unavoidable, then the use of reverse-engineered valuation models can be useful in minimising the biasing effects that stock prices can have on our thinking.
These two are simple things we can do to potentially improve our decision making, and hence, our investing results.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.