Measuring Expectations

Is it possible that even the most sophisticated institutional investor can be overwhelmed by emotion at times? Richard Cripps says yes. Recently, Cripps introduced his investment strategy to the brokers who make up Stifel Nicolaus & Company, Inc., the St. Louis, Missouri–based firm where he serves as chief investment strategist. The company significantly increased its presence in the Twin Cities with the purchase of MJSK Investment Securities last December.

In general, the idea of capturing over- and underreactions to the movements of individual stocks and markets isn’t new. But Cripps is using some of the concepts of behavioral finance to drive his investment thinking. A relatively new concept in investment theory, behavioral finance tries to explain in scientific, quantifiable terms the ways that emotions affect investor behavior. So far, it’s working for Cripps: After three years of managing money for one large institutional investor, he is well ahead of the market.

{Q} What makes your investment style and approach to managing portfolios different?

{A} We try to exploit investor over- or underreaction. Eighty percent of the time, the movement of the market is not an exploitable event. But 20 percent of the time, the market experiences an extreme over- or underreaction, which is when we believe that a misalignment occurs between the change in the price and the fundamentals of the company. Our investment process is designed to identify that and use that as a way to select stocks and manage portfolios.

{Q} How do you know when somebody is over or under-reacting? Aren’t markets supposed to be efficient?

{A} Yes, and in the long term, they do get it right. But individual stocks in particular go through periods where their price is disconnected from what its normal valuation should be. The best way to determine what stocks are experiencing extreme over- or underreaction is to look at them in the context of the market.

{Q} But doesn’t everybody try to do that?

{A} Yes, but we look at it in the context of 1,600 companies that make up our broad universe of stocks. Individual analysts sometimes have a much narrower focus in the industry group that they follow. What we’re looking at is change in the price and the change in the company’s expectations—forward estimates of earnings, sales, and other such measures. When we see a wide deviation between those two relative to 1,600 other companies, we’ve been able to identify a very focused group of stocks that we believe are mispriced.

{Q} To what extent could a dramatic price change reflect a higher discount rate or a higher expected level of risk being applied to those fundamentals?

{A} We know in hindsight that discount rates are very imprecise. So, we’re not putting that factor in there. As we know about discount rates, just changing them by one or even half a percent can theoretically give a much different answer for the intrinsic value of a stock.

{Q} You run a concentrated portfolio, yet on the other hand you try to weight sectors. is that correct?

{A} Yes. One of the portfolios we run is a sector strategy. We put our 1,600 companies into different sectors, using Standard & Poor’s definitions. We are then able to measure each stock’s current valuation relative to where it has been and, overall, determine which sectors are the most mispriced relative to their normal expectations.

{Q} An example of that?

{A} The best example of that is in the oil or energy market. Energy stocks all reached highs last May when oil prices were north of $70 [a barrel]. Since then, oil prices have dropped below $60, and most of the stocks have gone through corrections of 20 if not 30 percent.