A Tale of Two Companies

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Benjamin Graham

You may think that you are immune to the story that management tell you about their companies. However as charities & marketing professionals know, the reality is we are hard-wired to respond to stories far more than facts & figures. The market votes for the stories it likes with capital flows and it can take a long time for those stories to be weighed by actual future results.

Take for example the tale of two companies that I know well. Both are in the business of designing & manufacturing technology products (although in different fields.) Both have recently gone through a difficult period due to increasing commoditisation of their markets. Consequently both companies have undergone restructuring including outsourcing of manufacturing to China to reduce their production costs. However they have taken very different approaches to their accounting treatment of this period. Company A has presented all of their restructuring costs as exceptional costs to be removed from reporting. Company B has presented only a small bad debt as exceptional. Company A has also been regularly capitalising development costs whereas Company A has expensed theirs’. If you took the adjusted figures at face value you would likely conclude that Company A has been the most successful in their turnaround:

And looking at both the company fundamentals & chart the market appears to have voted this way:

(Blue is company A, Grey is company B, compared from the start of 2014)

However let's do a bit of weighing.

When we adjust for the capitalised development & exceptionals we get a different story:

Although the net margins for both companies clearly indicate companies undergoing challenges it is Company B that appears to have better navigated those challenges.

Net margins are of course not the only factor to consider. The story that the management of company A are telling is one of strong operational gearing. However when we compare gross margins we see that although company A has done well to increase theirs’ over the last few years they are still 10% below those of company B:

It would seem that company B is likely to have better operational gearing and a greater competitive advantage.

Free Cash Flow margins also seem to be the same or better for Company B:

What company A has been successful in doing is driving higher revenue higher, particularly in 2016H2:

(For ease of comparison revenue of company B has been normalised to company A 2014 H1.)

Although looking at the previous charts we see it has been at the expense of Net Margins & Free Cash Flow.

In these times of low economic growth in developed markets & record low interest rates the market has been paying a high price for revenue growth. Could this be the source of the difference in rating? I don’t think so since it is company B that has double the broker forecast revenue growth of company A:

All in all it would appear that company A is overvalued or company B is undervalued. Maybe both. It really does matter what story you tell investors and certainly at the moment investors are willing to ignore the adjustments made to tell the story. I think it is telling that company B is run by highly paid turnaround specialists with large stock option grants whereas company B is run by a long term managers. I look forward to the market weighing. 

Are financial discussion sites dangerous for our wealth?

There are many investment websites where private investors and market professionals discuss potential investment ideas. Seeking Alpha, The Motley Fool, Stockopedia and ADVFN are just a few of the ones I regularly read. They can often be a fantastic source of knowledge, wisdom and experience as contributors from all walks of life freely discuss their investment ideas and strategies. When you add in Blogs & Twitter there are a myriad of ways to read or share investment ideas. While there are undoubtedly some misleading contributions from people who manipulate information for their own ends, in my experience most people who post do so out of a genuine desire to gain and share knowledge. And experience teaches you to spot those whose opinion could be questionable.

So why do I think discussion boards have the power to lead us to poor investment decisions? Primarily because contributors to these sites make very public statements about their opinions and psychology teaches us that once we’ve done that we find it very hard to change our minds on a subject even when the facts change.

The desire to appear consistent is a very powerful psychological effect. Robert Cialdini explains this in his excellent book, Influence: The hidden power of persuasion. He describes how getting people to agree to and write down statements was used to great affect by the Chinese Army on American POW’s in the Korean War. The Chinese would start by asking a POW to agree to a simple statement such as ‘America is not perfect.’ Since this was undoubtedly a true statement as far as the majority of POW’s were concerned then complying with this request wouldn’t have seemed a big deal. However once they had written the statement the POW’s would be asked to write a list of ways in which America is not perfect. Once they had agreed in writing that ‘America is not perfect’ it became very hard not to comply with the second request and add some details. This list would then maybe read out on the camp radio with their name making the public commitment complete. Compared to the harsh conditions of the Korean POW camps the Chinese camps were far more effective at getting prisoner compliance. Breakouts were very rare and given their public statements of compliance POW’s often turned in fellow countrymen for minor rewards such as a small bag of rice.

Psychology researchers replicated this effect in a kinder setting in an experiment conducted in California. They approached households and asked if they would mind displaying a small sign on their lawn asking passing drivers to ‘drive carefully’. Since careful driving in their neighbourhood was a public good that all householders were interested in and the signs were not particularly disruptive it’s not surprising most of those approached agreed to display the small sign. The power of the desire to be consistent with one’s former actions was shown two weeks later when the researchers returned to ask if the householders would mind displaying a much larger and uglier ‘Drive Carefully’ sign that they’d mocked up in a brochure. Here over 50% of householders who’d displayed the smaller sign agreed to display the larger sign compared to less than 20%  in the ‘control group’ of householders who were not first approached to display the smaller sign. That’s a big change in average behaviour from a small public commitment.

The power of public commitment can be a useful aide when trying to do more exercise or give up smoking. However when it comes to the complex and rapidly changing environment of investing being fixed in one’s opinion is rarely good. Once we publically take a position, like a positive write-up of a company on a website, it becomes much harder not to commit further by buying shares or increasing a position. And much harder to sell a position for which we’d previously made positive public statements.

I sometimes I find this effect even manifests itself in the amount of research I do. The more I research a company the more I want to appear consistent to myself that the hours of work are worth it, the more likely I am to find justifications why this is a good buy (or sell) and more likely to take a position. Then given the amount of research done I’m more likely to share this publically and compound the effect.

And the most worrying thing about the ‘consistency’ effect is that we may be completely unaware of its influence on us. The same researchers who did the initial experiment with the 'drive carefully' sign repeated it but rather than using the small sign as the initial influencing factor they asked residents to sign a petition agreeing with ‘keeping California beautiful.’ Surprisingly this, effectively nonsense petition, had the same effect as the small sign in activating the residents’ sense of civic duty and led them to accept the large ‘drive carefully’ sign in almost a similar proportion. But more assiduously, whereas maybe some of the participants in the initial study may have thought ‘hang on a minute, I’m only accepting this large sign because I accepted the small one two weeks ago’ in this case I would imagine very few people made the link between accepting the large sign and the petition they signed a few weeks ago. Yet the evidence is that it was a significant influencing factor for many of them.

Sharing research and investment ideas can be a key part of getting feedback and improving your investment skills as well as being part of an active part of an online community. However next time you make a public statement about the investment merits of a particular share it’s worth thinking in advance of what events would cause you to change your mind and sell (or cover a short.) Even better write them down, so you have made a public commitment to yourself to change your mind if the facts change and you’ll at least want to appear consistent to yourself with that.