The Halo Effect & Rear-View Mirror Investing

My prior post focused primarily on the halo effect* in the context of Barron's recent survey of the World's Most Respected Companies.

In this post, I'll focus a bit on the tendency of investors to have their eyes firmly fixed on what's behind them. In other words, to weigh heavily what's in their rear-view mirror in lieu of what can be plainly seen through the windshield. It's a behavior that Warren Buffett did a nice job of explaining a little over ten years ago in this Fortune article:

Warren Buffett on the Stock Market

"People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them." - Warren Buffett in Fortune, December 2001

For market participants the tendency can adversely impact results if it's not well understood. Recency effect is a cognitive bias that creates a tendency to discount longer term trends in favor more recent events. What Buffett describes in the Fortune article is, at least in part, likely just the recency effect at work. The latest outcomes and recent experiences (good or bad) are projected forward as if they will continue indefinitely.**

As I mentioned, Barron's recently released its latest annual survey on the World's Most Respected Companies. In the prior post, I highlighted four companies that had fallen out of the top twenty of their rankings:

Berkshire Hathaway (BRKa): From 3rd to 15th
Pepsico (PEP): From 9th to 30th
JP Morgan (JPM): From 14th to 49th
Wal-Mart (WMT): From 18th to 51st

Barron's: The World's Most Respected Companies

So is there a company or two (not necessarily the above four) within the Barron's rankings with visible and very real near term difficulties, that led to poor stock performance, yet those difficulties have had little material impact on intrinsic business value?

If there is then comes down to whether that poor stock performance has put the price comfortably below a conservative estimate of valuation. The reason, of course, is that just because reputation has taken a hit or a stock has lagged hardly guarantees it's selling below intrinsic business value (nor does a favorable reputation and a rising stock price guarantee overvaluation).

The next question is whether the business is understandable to the investor. There will always be many businesses that seem cheap to me but I cannot make a reliable judgment of their future prospects. So a stock may, in fact, be a great investment but if it's beyond my abilities to make the judgment call I still can't take action. The discipline of knowing when not to act even if something appears compelling is not just somewhat important in investing. It's simple awareness of one's own limits.

This is one of several reasons why I believe an investor should never buy a stock based upon someone else's opinion. 
(Taking an idea you hear from someone, doing your own research and analysis, then drawing your own conclusions with some conviction is a different story.)

Another reason is this: If an investor concludes based on their own research to buy a stock, then when price action temporarily gets ugly they're more likely to hang in there. This is fine as long as judgment of intrinsic worth tends to be generally sound. If not, hanging in there ends up being a great way to assure substantial permanent capital losses. Things like the halo effect and recency effect are some of the many reasons stocks become mispriced. Use of more objective factors can reduce their influence on an investor, but remember that they are always at work even when aware of these and other tendencies and biases.

Finally, the damaged reputation of a company can, of course, be a reflection that the business franchise has really been materially impaired long-term and not just the result of some cognitive bias. 

That, as well as whether the reduced stock price is sufficient to reflect the impairment (and provide a safety margin), has got to be judged objectively on an individual basis. 

Adam

Long positions on all stocks mentioned

* The halo effect is essentially about how any one powerful impression can spill over to our other judgments. For example, it can make an investor believe they are evaluating a stock's performance (or maybe a series of negative headlines) independent of a business's intrinsic qualities (or maybe the CEO's capabilities), but there's plenty of evidence to suggest that's not what generally happens. 
** We also know from psychology that, due to loss aversion, humans get less satisfaction from gain than pain from loss. So it's not symmetrical. Humans much prefer avoiding a loss to acquiring gains. If the recent market trend (recency effect) involved heavy losses (or perceived losses), it's not hard to see why many would still want to avoid getting back in even well after the risk/reward has become more favorable.
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