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Thomas Macpherson
Thomas Macpherson
Articles (109)  | Author's Website |

The Overreaction Hypothesis

July 21, 2015 | About:

DISCLOSURE: We are long SWI

In 1863 during the battle of Gettysburg, Union general Daniel Sickles decided to move his troops far in advance of the line demarcated by his superiors. As the troops moved out with flags flying and bands playing, another Union officer – Winfield Scott Hancock – watched the movement with great consternation. One of his staff officers commented that Sickles’ was disobeying orders. General Hancock looked through his binoculars, sighed, and said “they’ll come tumbling back soon enough.” And indeed they did. Hit with an enormous wave of Confederate soldiers, Sickles and his men suffered enormous losses almost causing the Union to lose the battle – if not the war.

The Overreaction Hypothesis

I bring this up because a stock that was on our watch list, SolarWinds (NYSE:SWI), had been roughly flat YTD until – in the words of Hancock – it came tumbling back losing 24.5% last Friday. In one day, the company’s stock had gone from being roughly 10% undervalue to nearly 30% undervalue (Disclosure: We bought our shares on Friday at an average price of $35.77/share). A tumble indeed. Looking at the quarterly report and revised outlook, we think the markets clearly overreacted to the call. We will get into the numbers in greater detail later in this article, but it would be helpful first to discuss why the market’s overreaction is important.

A seminal work on this topic was published by Werner De Bondt and Richard Thaler in 1985[1]. In their study, Bondt and Thaler placed the top performing 35 stocks over the past three (3) years into a portfolio entitled “Winners”. Correspondingly, the worst performing 35 stocks were placed in a “Losers” portfolio. They then tracked each portfolio's performance against a representative market index for three years.

So what did they find? Interestingly, the “Losers” portfolio beat the markets handily while the “Winners” portfolio underperformed significantly. The cumulative difference between the two portfolios was roughly 25% over the three-year period. A case of inversion if we’ve ever seen one.

The essence of their findings was that for every overreaction in a stock price, there is an equal counter reaction. This works in both highly valued and low valued stocks alike. They described it as such:

If stock prices systematically overshoot, then their reversal should be predictable from past return data alone, with no use of any accounting data such as earnings. Specifically, two hypotheses are suggested:

  1. Extreme movements in stock prices will be followed by subsequent price movements in the opposite direction.
  2. The more extreme the initial price movement, the greater will be the subsequent adjustment."

They went on to state there were three (3) core propositions that make up the actual amount of the overreaction. These include:

  1. Directional Effect: Extreme movements in equity prices will be followed by movements in opposite direction.
  2. Magnitude Effect: The more extreme the initial price change, the more extreme the offsetting reaction.
  3. Intensity Effect: The shorter the duration of the initial price change, the more extreme the subsequent response.

SolarWinds: An Example

A case of the Overreaction Hypothesis is a stock that was on our watch list and now currently is a portfolio holding – SolarWinds (NYSE:SWI). This is a company we love to hold for the long term. Return on Equity of 21%, Return on Capital of 23%, no debt, $542M on the balance sheet, and conversion of 47% of revenue into free cash. Management has grown revenue at 21% annually since 2005 and free cash at 14% since 2010.

Last Thursday, management reported Q2 numbers. In addition to missing Q2 revenue estimates (while beating on EPS), the company guided for Q3 revenue of $130M-$134M (below a $136.1M consensus) and 2015 revenue of $502M-$512M (below a $519.7M consensus). EPS guidance was better: $0.49-$0.53 for Q3 (consensus is at $0.52) and $2.00-$2.08 for 2015 (consensus is at $2.00).

Anatomy of an Overreaction

These results provoked a collapse in the stock price – dropping to $35.54 or down 24.5% from its close of $47.05 on July 16. We were surprised by the reaction of the markets. SWI reduced Q3 revenue guidance by 4.5% but is still projecting 15%-19% Y/Y growth. 2015 revenue estimates were reduced by 3.5% but still projecting 17%-19% Y/Y growth. Using a DCF model, these changes reduced our estimated fair value from $54/share to $53/share or an estimated decrease of less than 2%. Friday’s loss would say that SWI is worth roughly 25% less today than it was last week. Followers of Efficient Market Theory (EMT) would tell us the price decrease represents the best information available and the true value of the company’s shares. We think this type of thinking is silly and a gross overreaction to Thursday’s earnings call.

Now that we’ve seen the massive downside movement, according to Bondt and Thaler we should see a short-term, significant upturn in price. That may be. But even if this doesn't work out, we have in our back pocket the ultimate asset for the value investor – an outstanding company selling at a significant discount to our estimated intrinsic value.

Conclusions

The Overreaction Hypothesis would tell us that for every market overreaction there is generally an overreaction in the opposite direction. Purchasing stocks that had such events on the negative side achieved significant outperformance versus those on the positive side. This makes sense as – generally - overreaction to the negative side can create opportunities at mispriced value. Those on the upside have generally stretched valuations. Whether SolarWinds is a successful example of the Overreaction Hypothesis will be tested over the next several months. Combined with its valuation, this is a transaction where we think the odds are in our favor over the long term.

As always we look forward to your thoughts and comments.


[1]Does the Stock Market Overreact?”, Werner F. M. De Bondt and Richard Thaler, The Journal of Finance, Vol. 40, No. 3, Papers and Proceedings of the Forty-Third Annual Meeting American Finance Association, Dallas, Texas, December 28-30, 1984 (Jul., 1985)

About the author:

Thomas Macpherson
I served as CIO of the Nintai Charitable Trust and consult with Dorfman Value Investments as an investment advisor. I look for companies with high ROIC, significant free cash flow, no debt and that trade at a deep discount to fair value. Much of my writing consists of thoughts on the Nintai Charitable Trust portfolio. I am the author of "Seeking Wisdom: Thoughts on Value Investing". It is a book written to get investors thinking differently about their investment approach. Unless otherwise stated, views represented in my articles are based on my former role as CIO of the trust, which I personally managed.

Visit Thomas Macpherson's Website


Rating: 5.0/5 (5 votes)

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Comments

Adib Motiwala
Adib Motiwala - 2 years ago    Report SPAM

Hi Thomas,

I see $255m Cash and investments. Where do you get $542m from?

Also, a large part of Cash flow is stock comp expense. $25m in 6months out of $92m in OCF. The growth and margins and FCF conversion is great. Does the growth make up for the higher valuation at the moment?

thanks for sharing the idea

adib

Belarophon
Belarophon - 2 years ago    Report SPAM

Hi Thomas,

I can't find the $542 on the balance sheet either. What I like about them is that they are debt free, have nice growth rates (for revenue, earnings, cashflow and equity) and a positive outlook. But almost all the numbers you are writing about are Non-GAAP. Their GAAP-numbers are much lower because they take out stock comp expense (~ 26m in the first 6 months) and also amortization of intangibles (~ 16.6m). In my opinion these are real costs or am I wrong? On a GAAP-Basis they don't really look cheap enough (based on P/E). And ROE and ROA are good but not really great. Nontheless good idea. I guess I'll take a look at their annual reports to find out more about their anorganic growth (432m of goodwill have to come from somewhere) and their stock options... Maybe the price drop is really good in regards of outstanding stock options.

Regards, Markus

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Interesting idea; I will need to look at it more closely. Thanks Tom!

Praveen Chawla
Praveen Chawla premium member - 2 years ago

Interesting idea. I observed the same recently with UTX. The stock was chugging along and then boom 20% correction in short order.

With SWI the excessive stock option comp identified by Adib supra is worrying as it speaks to agency problems and governance. Its mostly the case when there is a big gap between GAAP and cash accounting (pun intended)

Thomas Macpherson
Thomas Macpherson premium member - 2 years ago

Adib and Markus. Thanks so much for your comments. I wish I could say we had some inside knowledge about SWI's balance sheet, but the simple answer is that fat fingers and editing failures are the explanation for the cash number. I will update the article to reflect the correct number. As to the GAAP/non-GAAP numbers, this is one item that drives me to distraction about SWI's management. I recently wrote to them to ask them to stop reporting in non-GAAP but haven't heard back. I use these numbers simply because that's how they report and people always write in questioning our sanity when we use GAAP. Thanks again for your comments. Best. - Tom

Thomas Macpherson
Thomas Macpherson premium member - 2 years ago

Pravchaw. No doubt troubling though the explanations as provided by management allay our fears to a manageable level. Thanks for your comment. Best - Tom

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