Surprises and the link between valuation and momentum
– David Wanis, July 2019
As we prepare for another reporting season we know there will be surprises – but by definition we don’t know where. We will see share prices move more than ‘rational’ investors believe is warranted and if prior reporting seasons are a guide, we will see active small cap managers deliver one month returns from best to worst in a range of 10% or more. It is understandable that company results are surprising time and time again – after all expectations are simply the best guess at what the future holds and reality will always be hard to pin down ahead of time. Given the wealth of evidence, it is interesting investors remain continually surprised by the magnitude and persistence of the market reaction. We believe there is evidence of a behavioural bias which relates to how valuations are built and how investors update their prior beliefs through time. This effect is particularly pronounced in small caps.
The movie version of an analyst’s valuation looks something like this; an analyst builds a deep understanding of a company’s prospects by researching the business, the industry, talking to management, building a financial model of future cash forecasts and then deriving the net present value of those cash flows to determine what the company is worth today. The analyst has high confidence in this work, if the price is lower or higher than the estimate then the analyst can invest to exploit the difference and wait for the market to find an equilibrium at the (analyst’s) truth. A good valuation doesn’t change much through time and investors can trade on the difference between current price and value. A bad valuation moves around a lot through time, reflects a lack of conviction and understanding of ‘the truth’ and can’t be relied on to make investment decisions. There is a behavioural incentive for valuations to be sticky if analysts want to be seen as good.
The reality of determining the value of a business is; the cash flow forecast is a probability weighted guess of the many and varied futures a business may encounter. History however travels only a single path. As forecasts become fact, the path travelled may be significantly different to the central estimate. New information may indicate one of the lower probability outcomes (either significantly better or worse for sustainable cash flow) are now more likely. This raises a range of questions for the analyst: In the face of new facts, how do we update our estimates? How significant are the differences in valuation at the different ends of the distribution? How quickly do we incorporate these new estimates into our valuation? How do companies differ in the range of potential outcomes? How do we reflect different uncertainties between companies and changing uncertainty through time in our discount rates?
One of the theories behind why momentum in stock prices persist is that investors take time to update their prior views once new information comes to hand. Using a probability of future cash flow framing; this is akin to new information changing which of many possible futures is likely to become the single history for the firm. One way of testing this hypothesis is to see if companies with greater levels of uncertainty show stronger momentum effects in their stock prices. The logic being that ex-ante these companies have a wider potential range of outcomes that are only revealed through the progress of time. Observed momentum effects are a reflection of new information being incorporated into valuations, but the analyst valuation anchoring biases mean they occur more gradually (and with directional persistence) than theory may suggest.
Statistical studies (Information Uncertainty and Stock Returns, X. Frank Zhang, The Journal of Finance, Feb 2006; Price Momentum and Idiosyncratic Volatility, Arena, Haggard, Yan, Feb 2005), show companies with higher uncertainty, that are younger, that are smaller, and that have higher share price volatility show more persistent momentum in their stocks prices – both up and down.
Share prices are a result of the disagreement between investors about which future is more likely. Within small caps (due to higher uncertainty and a wider range of outcomes) the impact new information has on share prices and the persistence of this impact is much greater than other parts of the market. Once again, small caps differ from large caps in more than just form.
Research, experience, investment process and discipline can improve the odds of getting this right more often than the market, but sometimes new information will require prior beliefs to be updated – not just for near term earnings estimates, but for the long-term value of the business. Stubbornly holding onto a version of history an investor would like to have occurred in the face of contrary facts is unlikely to be a winning investment strategy.
So, this leads us to expect to see large share price moves as companies report full year results during August. To expect investors to be surprised by how much prices move and be prepared for some of the new information to take time to be fully reflected in the ‘version of the future’ investors now believe. Although momentum is a dirty word for many investors, recognising the underlying valuation mechanics may be a more useful interpretation of reality.