Avoiding herd behaviour in emerging markets

When it comes to investing, many people believe behavioural biases influence prices. Hard-wired human behaviour has been partly to blame for share price movements that are more dramatic than changes in company fundamentals.

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When it comes to investing, many people believe behavioural biases influence prices. Hard-wired human behaviour has been partly to blame for share price movements that are more dramatic than changes in company fundamentals.

By Steven Gray

When it comes to investing, many people believe behavioural biases influence prices. Hard-wired human behaviour has been partly to blame for share price movements that are more dramatic than changes in company fundamentals.

In a complex market environment, many investors display behavioural biases such as anchoring on irrelevant information, herding around common beliefs, over-optimism, as well as over-pessimism and local representativeness bias, in which people assume a sample of recent or local observations represents all potential outcomes.

En masse, such behaviour can cause share prices to overreact to actual or perceived changes in a company’s fundamental position, such as when the market extrapolates a disappointing recent quarterly result into a long-term trend.

These behavioural biases can be seen in emerging markets today, creating a mispricing episode that is contributing to a Quality Bubble. Equity market investors are paying an ever higher price for defensive and quality stocks at the expense of cyclical names. As a result, the valuation gap between popular stocks and out-of-favour stocks is approaching levels seen in prior bubble episodes.

What are we seeing? The current episode has disproportionately favoured certain sectors as investors choose to reward expensive defensives and growth stocks, which together are labelled as “quality” for their perceived superior characteristics.

Looking at the sector concentration of the most expensive and cheapest stocks in emerging markets, more than half of expensive stocks were concentrated in just three sectors. Our analysis shows these to be in IT, consumer staples, and consumer discretionary. The richly-valued stocks are defensive staples firms (safety) and darling tech companies (growth). The cheap stocks demonstrated an even greater concentration, with the vast majority of the universe’s cheapest issues in the financials, energy, and materials sectors. Interest rate sensitive and cyclical companies, such as banks and energy producers, are deeply discounted.

Investors have to ask themselves whether this valuation disparity is reflective of underlying company fundamentals or caused by other factors.

It could be that recent bias is at play. This is a cognitive bias that leads people to extrapolate recent observations. We are hard-wired to place more emphasis on our most recent experiences. Given this, extrapolating the current low interest rates landscape can have a large impact when valuing future cash flows. Utilising a low interest rate when analysing New Economy tech stocks may make large but distant future cash flows look overly attractive.

Herd behaviour also magnifies biases. A positive feedback loop occurs when investors herd around common observations. This behaviour appears to be present in the price action of tech stocks, which the broader market continues to reward with some of the highest valuations in emerging markets. Herding can result in inappropriate risk-taking relative to the company fundamentals, irrationally driving prices.

As a result of these biases there are great opportunities where there is the largest difference between the price and the intrinsic value of a security. Value can be found in stocks in the energy, utilities, and financials sectors and in positions, including holdings in Chinese and Indian energy producers; banks and insurers in China, Korea, India and Brazil; and utilities in Korea.

People have a tendency to overpay for comfort and safety. This may be seen in the current mispricing episode. Market history is replete with examples of euphoria and pessimism. Although the popular flavour of the day may differ, mispricing episodes and bubbles reoccur because of the presence of hard-wired human biases. History shows that such periods of extreme mispricing are followed by mean reversion. Although it is difficult to predict when a reversal will occur, it is somewhere on the horizon.

 

Steven Gray is a portfolio manager at Eastspring Investments

 

 

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