Evidence supports the idea that markets fail to properly price information about companies that experience seasonal patterns in their earnings. The authors show that the abnormal returns exhibited by the stock prices of such companies are caused by market participants affected by behavioral biases.
The idea that a company’s business is seasonal is nothing new. What is new is trying to understand why the market is not properly pricing for this seasonality. The research suggests that investors and analysts overweight the more recent lower-earnings quarter, leading to a more pessimistic forecast, and subsequently underweight the positive seasonality quarter. For those companies that exhibit seasonality in their earnings, the median analyst correctly forecasts 93% of this seasonal shift in earnings, missing only 7%. Although this finding shows that analysts are taking the seasonal nature of the earnings into account, they are not fully adjusting their forecasts and properly accounting for earnings seasonality.
The recency effect is the tendency of people to be most influenced by what they have last heard or seen. Not surprisingly, investors suffering from the recency effect will be more likely to overweight recent lower earnings compared with the higher seasonality earnings from the year-ago period. Related to the recency effect—and perhaps an additional factor contributing to the mispricing—is the availability heuristic, which operates on the notion that something that can be recalled must be important.
Consistent with the predictions of the recency effect and the availability heuristic, when recent earnings are lower, the seasonality effect is larger. The authors find monthly excess returns of 65 bps in an equal-weighted portfolio and 76 bps in a value-weighted portfolio, both significant at the 1% level.
Read the entire article here. - Paul R. Rossi, CFA
Driven by funding and actuarial considerations, state and local public pension plans have been seeking additional investment options and are increasingly using alternative investments in their portfolios. Pension fund managers are potentially motivated to invest in alternative investments by several factors: including demographic shifts, general budget challenges, and two recessions. In trying to deal with these challenges, state legislators have changed laws and state pension systems have decided to shift their allocation strategies away from traditional equity and fixed-income investments to alternative investments. These alternative investments include hedge funds, private equity, and real estate. However, is this really a good strategy?
My thoughts go back to Warren Buffett’s 2008 $1 million bet with a hedge fund manager. The bet was simple: Buffett bet $1 million that over a 10-year period, the S&P 500 Index would beat a hand-picked portfolio consisting of five hedge funds. As we head into the final year of the bet, Buffett’s bet looks most assured. He explained that the costs of active investing, despite the intelligence of hedge fund managers, are greater than the benefits to the investor. In 2014, CalPERS, the largest public pension in the United States, stated that it is no longer investing in hedge funds, stating the decision was primarily driven by costs and complexity - at least somebody is listening. While hedge funds and other so called alternative investments have the allure of producing greater returns than the stock market, history has proven otherwise.
Click here to read my entire abstract article published by the CFA Digest. - Paul R. Rossi, CFA