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Eye On Behavioral Finance: Groupthink

“In the fight between you and the world, back the world.”
-Franz Kafka

Franz Kafka posthumously became renowned for his writing, but while alive actually made his living, ironically, in the finance department of a large insurance company. One of Kafka’s most widely noted works is The Trial. The protagonist in The Trial, Josef K, is awakened one morning, arrested and prosecuted for an unspecified crime. The reasons for the arrest are never known. I’m sure after suffering through an almost 40% decline in the major market indices year-to-date, many investors can relate to Josef K and the idea of being punished for an unknown crime…

While the trials and tribulations of Kafka’s characters may resonate with us, it might be perceived as a stretch to think that we can learn many investment lessons from them. That’s why the aforementioned quote prompted the topic for this post, which is Groupthink. The concept of Groupthink was reportedly first coined in 1952 by William H. Whyte when he wrote in Fortune Magazine:

“We are not talking about mere instinctive conformity – it is, after all, a perennial failing of mankind. What we are talking about is a rationalized conformity – an open, articulate philosophy which holds that group values are not only expedient but right and good as well.”

In simpler terms, and paraphrased from Wikipedia, Groupthink is a method of reaching a consensus decision without critically analyzing the decision, but rather accepting the decision, or view, as correct simply because others support it. The idea of the independent view is lost out, ultimately, to the importance of group cohesiveness.

The investment world is loaded with examples of Groupthink and investment results that are subpar as a result. At Research Edge, we actually quantify Groupthink in order to augment an existing investment thesis’ and take positions that counter the prevailing view. We use various methodologies to counter Groupthink. We quantify them as factors within our multiple factor macro model. Two of the easier factors to identify are Hedge Fund Beta and Sell Side Sentiment.

We review shareholders lists to identify Hedge Fund Beta (or “hedge fund hotels”). We also review sell side opinions to identify stocks that have an overwhelming number of either positive or negative ratings.

I’m not sure “hedge fund hotel” has entered the wide investment lexicon as of yet, but the concept is simple – it is a stock that has a high percentage of hedge fund ownership. We typically consider a stock a “hedge fund hotel” when hedge funds comprise 33% of the top 1/3 of a shareholder list. For many hedge funds “trading ideas” are part of the investment process, so as these “hedgies” trade ideas, the “good” ideas tend to become over owned. In many instances, the investment rational is simply that some other “smart hedgie did the work”, so it must be a good idea and there are certain “smart hedgies” who you can’t criticize, so you just tag along and own the same stocks as them. That’s called Groupthink. We also call it Hedge Fund Beta. Being on the other side of the unwinding of a “hedge fund hotel” can be very profitable.

Sell side estimates and ratings also exemplify Groupthink characteristics that can be taken advantage of. We typical highlight as a contrarian indicator when 66% of the rankings of a stock are of one specific rating, either buy or sell. There is a wide body of evidence that supports our view that the consensus Groupthink ratings of analysts are often way off.

According to research by Robert Shiller, “analysts . . . often pay too much attention to one another instead of providing their own independent research.” The result is that both ratings and earnings estimates become redundant and are often lowly dispersed. According to Maines (1990) and Soll (1999), people often overestimate the information provided in redundant signals. As a result, we have sell side earnings estimates that are based on a foundation of conforming to consensus and an investment community that willingly accepts a lowly dispersed set of data, which inherently implies a lack of independence.

The psychological foundation behind Groupthink is based on the biological concept herding. In his book “Inside the Investor’s Brain”, Richard Petersen writes:

“Biologically speaking, herding refers to the tendency of some species of animals to seek safety in numbers. Herding occurs both when animals are threatened and when they sense that one of their numbers has found an opportunity.”

Hedge funds, and many mutual funds, are in a financial herd. Some justify their positions based on who the stock is owned by and what the well known analysts are saying. If a “smart hedgie” owns the stock and a bulge bracket investment bank has a favorable rating, a safe foundation is in place for the analyst to pitch the stock to his portfolio manager or investment committee. Conversely, these conditions also provides the portfolio manager or investment committee the “safety” to put on the position. What happens when all of these smart sell side analysts and hedgies are wrong?

In The Wisdom of Crowds, James Surowiecki provides what appears to be a juxtaposed thesis to the negative impact of Groupthink. In Surowiecki’s view, the collective knowledge of the many will lead to a better decision than a small group of intelligent experts. He provides many examples of this, such as the ability of electronic markets to predict elections better than professional pollsters, the ability of large groups to accurately predict the weight of an ox, the ability of a large group of varied professionals to find a submarine, and so on. Surowiecki, though, acknowledges early on in his book that all crowds are not created equal when he states: “Paradoxically, the best way for a group to be smart is for each person in it to think and act as independently as possible.”

There are plenty of ways to combat Groupthink. Here are a few to consider:

1. Perform research with independence at the very foundation. Start by developing your own view and then review other analysts’ expectations. When your view is most widely dispersed from the group, you are probably on to something that is worth taking a position in.

2. Foster a culture in your firm that encourages devils advocacy and taking contrary opinions, even against people in positions of power and influence. At Research Edge, we sometimes publish what call “Point and Counterpoint”, which are examples of our internal debates on different investment views that members of our firm are supporting.

At the end of the day, we call it Research Edge because most of the real edge in investment research resides on the teams asking original questions… not following everyone else’s answers to ones that have already been asked.

Daryl Jones
Managing Director
Research Edge LLC

UA: Texas (Tech) Sized Brand Exposure

On Monday, Under Armour and Texas Tech University announced a new partnership that designates the company as the university’s exclusive performance footwear and apparel outfitter. Under the new 5-year $11M deal, UA will outfit all 17 of Texas Tech’s teams in addition to football, which it has outfitted since 2006. This announcement came at a great time.

Less than two weeks ago, the Red Raiders upset the #1 Texas Longhorns in front of a nationally televised audience vaulting the school to #2 in the BCS rankings. In the process, both Graham Harrell (QB) and Michael Crabtree (WR) solidified their respective case as legitimate Heisman candidates. If the team can complete its remaining schedule (bye week, #5 Oklahoma, and Baylor) unbeaten, the Red Raiders should be vouching for a national title bid in the BCS championship game (talk about brand exposure). Notably, the University of Utah ranked #7 at 10-0 is another UA outfitted team in the BCS mix. Would I rather this deal have been signed before the big win? Yes. It would have saved UA a buck or two. But overall, the terms seem fair.

Despite all the hype, it’s important to not lose sight of how these deals have been struck. As Brian pointed out in his 9/28 post “I’m Warming to the Armour,” the company tends to take a more conservative approach by front-end loading its endorsement deals (less than 5yrs). The same appears to be true for its sponsorship deals. In September, UA inked a 5-year, $17.5M deal with the University of Maryland following an 8-year, $4.1M deal with the University of Hawaii in February. As a point of reference, earlier this year Nike signed a 10-year, $46M exclusive sponsorship deal with UConn.

The company currently outfits five other football programs including the University of Maryland, University of Hawaii, Auburn, University of Southern Florida, and the University of South Carolina. However, with UA’s newly announced sponsorship of the NFL Combine beginning this year and the second annual high school Under Armour All-American Game in January, we expect more teams to be wearing the UA logo come next season.

I’m not going to sit here and argue which company is striking better deals at better prices. But what I can say is that UA’s terms and duration both sit well with me – especially given that its endorsements result in new exposure, whereas I can argue that Nike’s deals are largely to maintain its massive existing share of consumer voice.

Casey Flavin
The country takes notice as Michael Crabtree and Texas Tech pick off the #1 Texas Longhorns on Nov 1.


The good news: Beijing is letting significantly more tourist groups visit Macau. The bad news: they may not be gambling much.

My guys on the ground in Macau are reporting that the number of tourist groups visiting from mainland China is double what it was before the new visa restrictions were enacted. It looks like Beijing is making an effort to support the Macau economy. Unfortunately, the effort is unlikely to help the mass market casino floors much given the limited time allowed the groups in Macau.

Considering the likely demographics and economics of these visitor groups, Beijing is not exactly providing a significant shot in the arm of the casinos. If this were its intention, they would’ve just loosened the individual visa restrictions.

Beijing seems unwilling now to repair the damage created by 3 rounds of visa restrictions and is instead targeting essentially non-casino parts of the economy. Unless business levels deteriorate significantly from here, we may not see any loosening until the new Chief Executive takes over late next year.

The near term is certainly frustrating, as it is for virtually every other casino market. At least Macau still attracts excess demand. I can’t say that for any other market in the world.

The New Off-Price Retail Paradigm?

Ever have one of those situations where your logic, gut, and calculator all tell you different things? I’ve got that with TJX and off-price retailers. I think that’s the next shoe to drop in ’09.

I’ve been struggling with the analysis below for the past hour. The first chart shows the spread between the cash cycle for the apparel brands vs. the off-price retailers. As the brands profess to have found religion on inventory management, the cash conversion tightened between them and the off price retailers. Makes since due to meaningfully less inventory built up in the system. Then the second chart shows that there is a 0.57x relationship between changes in this cycle and EBIT margins for off-price retailers such as TJX and Ross Stores. The simple conclusion? That cash spreads have inflected, and as they build it is a positive for the off-price retail channel.

I don’t buy this.

I’m absolutely not being contrarian for argument’s sake. But I simply don’t think that the past seven years are an appropriate gauge of the relationship between off price retail and the rest of the supply chain. The past seven years were golden. Even the worst of the worst could make money. Strong consumer spending, $4bn+ in annual sourcing dollars injected into the industry, FX tailwind, etc… The number of apparel/footwear retail bankruptcies was less over the past seven-year period than at any other time in history. But this is a New Reality. The bankruptcy rate has started to tick up – and will do so much more meaningfully in 2009. Fans of TJX will tell me that this means better inventory for TJX. I say that this means that a new off-price retail channel will be created where one previously did not exist as legacy stores go bust. The magnitude of excess inventory will be too much for the existing off-price channel to bear.

With this channel currently running near peak margins (see Exhibit 2), there’s not a whole lot of room for error.

Keep Your Eye On the Cash Cycle

The direct transfer of cash from footwear brands to manufacturers in Asia is unmistakable. But why should it stop here?

My team and I geeked-out this weekend in analyzing balance sheet trends between different segments of the apparel and footwear supply chains. One trend that jumped right out at me was in the footwear space, and the direct transfer of value from the US to Asia. Over the past seven quarters, the cash cycle for the footwear brands went up by 30 days, or 25%, to 143 days. Over the same period, the Asian Manufacturers saw a 20% improvement in its cash cycle to 117 days.

Another notable trend on the chart below is that as the Brands became increasingly stressed from a cash standpoint, they passed it through to the retailers – or at least attempted to. There was never a quarter in the past seven where both the brands and the retailers improved their respective cash cycles simultaneously.

Given capacity closure in Asia – especially China – I remain convinced that the pendulum will swing further into the hands of the sourcing side of the equation. Will the cash cycle continue to erode for the brands? Yes, it should. .If not, then there is an equally unappealing option – paying higher prices for COGS (otherwise known as FOB). A worst case would be higher FOB and less favorable cash terms. We have not seen that yet, but there’s no reason why it can’t happen.

Eye On Regulation

This is a commentary on recent regulatory developments from our Director of Compliance, Moshe Silver, an industry expert who has held senior positions at major asset management and brokerage firms and brings a wealth of experience and insight to our team. Moshe has agreed to share his thoughts with our audience in a regular weekly report.

We believe in a collaborative network of thought. We believe that everyone that works in the industry can benefit from his insights.

Keith McCullough & Andrew Barber
Research Edge LLC
Regulatory tidbits for the week ending Friday 14 November 2008

Last weekend’s Wall Street Journal featured a story (page B4) headlined “SEC Won’t Discipline Its Enforcement Chief”, which puts to bed the flap over allegations of misconduct by Linda Chatman Thomsen, head of the SEC’s Division of Enforcement. The problem is, the bed appears to have been short-sheeted.

The short version is: (Paragraph 3 of the Journal’s story) – “One report by the [SEC office of the] inspector general found Ms. Thomsen had improperly released information about an insider-trading investigation involving hedge fund Pequot Capital Management and John Mack, a well-known Wall Street executive. The inspector general concluded Ms. Thomsen improperly relayed information when she told lawyer Mary Jo White, who was working for Morgan Stanley’s board and vetting Mr. Mack as a potential chief executive, that there was smoke but not fire in the investigation.”

The Financial Times on-line edition – FT.com – writing on Sunday 8 November, reports that SEC chief administrative law judge Brenda Murray ruled last Friday that Ms. Thomsen did not deserve to be disciplined for her actions. In a revealing paragraph, the story says that Judge Murray found Enforcement Chief Thomsen’s actions to be exempt under the SEC’s code of conduct, because her remarks to attorney White were in the context of activity, in which Ms. Thomsen was discharging “other official responsibilities.” Just what were those “other official responsibilities”? Again, according to the FT.com story, Judge Murray found that, in view of the important position in the financial markets occupied by Morgan Stanley, Ms. Thomsen was properly discharging her responsibilities by providing the information.

Ms. Thomsen had been accused of improper conduct relating to her role in the 2001 investigation of a windfall $18.9 million profit at a firm whose CEO was a business partner of John Mack, and the subsequent termination of the SEC staff attorney who sought to subpoena Mr. Mack in connection with the transaction.

The New York Times reports, on 10 November, that a Senate investigation agreed with the 191-page report issued by the SEC’s Inspector General H. David Kotz, who found “serious questions about the impartiality and fairness” of the Pequot investigation, and recommended that the Commission consider disciplinary action against Linda Thomsen, as well as against Mr. Aguirre’s direct supervisor, Robert Hanson, and assistant director of enforcement Mark Kreitman. For the record, we note that Judge Murray’s findings exonerated both Ms. Thomsen and Mr. Hanson, but that no determination has yet been reached regarding Mr. Kreitman. This sounds like someone may be retaining a spare goat, just in case a sacrifice is called for.

It is interesting to note that the SEC’s own legal process finds that it is appropriate for the Enforcement Chief to be tipping off the private sector as to the status of an ongoing investigation. Mind you, we make no value judgment on this determination. It has long been a commonplace of the US economic system that “Free Markets”, in AmeriSpeak, really means “Regulated Markets,” and more often than not, “Manipulated Markets”. And who better to manipulate a market than that market’s own regulatory authority?

Of course, now the vultures are coming home to roost. Morgan Stanley, headed by Mr. Mack, is the recipient of a Federal banking charter, and a large dose of taxpayer largesse with which to stuff its internal ATM (“Avarice Titillation Machine”). This means that Mr. Mack, who is so above reproach that he doesn’t even need to be investigated, now gets to go back to the tables where he can continue to pay himself handsomely for continuing to place losing bets on black, this time both paying his own compensation and placing his wagers with my money and yours.

Let us not be needlessly ironic. If the Feds believe there are entities in the market that are so important that the “official” position of the law enforcement agencies should be to shield them – if the Feds believe the Morgans and Goldmans and Bears of the world are too important to the global financial system to be permitted to fail – then this is a truly appropriate use of taxpayer dollars. We should rally in our thousands to show our support for the embattled Messrs Mack and Blankfein, Kohlberg and Schwartzman. God bless America, and God bless our Chief of the SEC Division of Enforcement!
In other news…

The SEC and the CFTC are engaged in a high-stakes turf war over who will get to regulate the market in Credit Default Swaps (CDS). Why would anyone in their right mind want to be put in charge of toxic waste cleanup? Two possible answers spring to mind.

First, whoever steps in now can only be a hero. Like the closer who is called to the mound for the ninth inning with his team down by two runs: all he has to do is hold the other team. He cannot lose the game officially; and if his team scores, he will be the winner of record. Here, no regulator can possibly do a worse job of regulating the now-unregulated marketplace. Anything at all will be seen as major progress, and the turmoil in the rest of the world will probably ensure that the mere fact of putting someone visibly in charge will mean that this vast market will drop its Red Alert status in favor of the next emergency du jour.

Oh, and second… Chairman Cox, in his testimony before Congress last month mentioned that this is a $58 trillion notional market. According to a report in NSCP Currents (January/February 2008) SEC civil fines and disgorgements are actually down year-over-year, from $3.3 billion in fiscal 2006, to a paltry $1.6 billion in 2007 – a 52% decline. The article goes on to observe that recent years have seen an increase in the number of small fines, and a “dramatic decline in the number of large sanctions”. We are sure that tackling the CDS market will give its new regulator ample opportunity to shake a tree or two, where even the low-hanging fruit is going to be very juicy indeed. Which agency is going to get first crack at this new honey pot? We surmise that the size of the kitty itself may be sufficient to force the merger of these two agencies into a single Uber-regulator. Stay tuned.
In other news…

We were impressed by the position of Acting (and outgoing) CFTC Chair Walter Lukken. Speaking on 11 November at the FIA Futures and Options Expo in Chicago, Mr. Lukken made the unusual observation that rules-based regulation doesn’t work and called for the creation of a new regulatory system to stand firmly on three legs: a Systemic Risk Regulator, a Market Integrity Regulator, and an Investor Protection Regulator. Bit by bit, we seem to be getting the notion that principles-based regulation makes sense.

There was an old saying in the brokerage business: a lawyer is someone you go to after you break the law; a compliance officer is someone you go to before you break the law. Meaning that the job of the compliance officer is to tell you how to break the rules without getting caught. How many times in the course of my career have I been told in all seriousness – by the owners and senior executives of firms, by the top producing traders and salesmen at firms – indeed, by the outside counsel of firms –we want to operate in the Grey Area.

Rules are signposts. Like trees on a ski slope, you don’t want to crash into them. But as long as you can steer around them, there is nothing to prevent you from tearing down the trail. In the financial services industry (an odd appellation – who gets “served”? not the investors!) is to use the rules as an early-warning system which enables participants to channel their unrestrained greed into areas where regulators have not yet figured out how the money is made. As rules proliferate, the clever players migrate to uncharted waters. In mathematical terms, they move out of the fat part of the distribution and into the statistically-insignificant tails. Rules are by their nature conservative, and rule-makers tend to be backward-looking. Rules are always made to prevent yesterday’s violations and yesterday’s disasters. Thus, as new rules fill up the already highly populated center of the bell curve, the creative professionals move farther out along the tails. Where more money is to be made, at the cost of more risk to the system. And, the more risks that get regulated away as they come to light, the more extreme are the new risks that the whiz kids and Masters of the Universe create. As we point out in every macro call: everything important in our world happens at the margins. At the margin of financial markets regulation lies an abyss of risk. On ancient European maps of the world, the unexplored regions were represented by the legend “Here be dragons.” Did you not get what is wrong with this system? Do you get it now?

Thanks to Acting Chairman Lukken for spelling out a sensible approach to a regulatory structure. Mr. Lukken leaves out the sticky bit about implementation. There is so much embedded bureaucracy, so many careers that have been built on the rules-based hierarchy, that Mr. Lukken’s recommendation turns out to be a generational change. In order to make anything like this work, lots of people in government will have to be fired.

Sounds like a good idea to us.

Moshe Silver
Director of Compliance
Research Edge LLC

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