Brilliant CFA interview with C. Thomas Howard on behavioral investing. Howard takes an unconventional approach, but there is some solid research backing up his process:
What are the five criteria?
One is dividends; we buy stocks that pay dividends. Companies that pay dividends are saying to the market, “We believe we have earnings into the foreseeable future.” It’s a powerful signal. It’s putting your money where your mouth is. In identifying behavioral price distortions, I look for situations where people are putting their money where their mouth is.
Analyst earnings estimates are the second factor. Based on the forward P/E, analysts are saying they believe there’s enough future earnings to justify the current price. Now I have two opinions on the company—management’s opinion and the sell-side analyst’s.
Third, I want companies with as much debt as possible. If I find one with negative net worth, I’m thrilled. Now, when most people hear that, their lip curls and they say, “That’s bad.” The reason debt is attractive is because the underwriter or the bank worked closely with the company and decided they could make the loan and the firm would repay it. I’ve now got a commitment from three sides—again, people putting their money where their mouth is, saying, “Yes, we believe in this company.” The greater the debt, the better I like it.
Then, I use a price-to-sales ratio. Sales are the least manipulated of accounting measures and have been shown to be one of the best predictors. And I have a minimum sales threshold. Those are my five criteria.
Aren’t these basic balance sheet metrics rather than distortions?
They are distortions. Investors tend to underreact to dividends; they don’t realize how powerful a signal it is. The typical response to dividends is a downgrade of growth prospects. It turns out it’s just the absolute opposite of that—the higher the dividend, the higher the return, the higher the growth of the company. Investors also tend to overreact to debt. If a company has lots of debt, they tend to run away from it. I’m harnessing these particular behavioral mistakes.
What names do you hold in your portfolio?
I don’t know the names of the stocks I own.
Really? Are you serious?
How does that work on an operational basis?
I have to know them long enough to tell our traders to trade them, but beyond that, I don’t remember the names. The reason is a component of my process. I ruthlessly drive emotion out of my decision process. I make no attempt to remember names any longer than it takes for me to say, “Trade this stock.” I just don’t remember. Now, I do look at them from time to time. They’ll float through my brain, but it’s nothing that I keep track of.
Why should I remember the name of a stock? It’s not part of my process. I believe the name of a stock creates emotional problems. You could wipe out the name and call this stock “123.”
Are you saying you don’t place importance on names, or are you actually saying you don’t remember the names?
I literally don’t know the name. I cannot name the 10 stocks that I currently own.
Read the rest of C. Thomas Howard’s interview with the CFA Institute Magazine on behavioral investing.
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