Fundsmith, a British investment company, is dedicated to value investing, and to thinking outside the box. It makes frequent reference to John Templeton’s famous maxim:
"If you want to have a better performance than the crowd, you must do things differently from the crowd."
In a 2013 report, Fundsmith developed some interesting insights on why high-quality, value stocks often prove to be bargains. Drawing on the behavioral psychology of Daniel Kahneman, Fundmith attempted to show why certain value stocks find themselves undervalued.
Let’s see what Fundsmith found, and how its insights might aid investors today.
A problem with probability
Kahenman’s “Thinking, Fast and Slow” has become a modern classic of behavioral economics. In it, he highlights many unconscious biases that can lead to poor decision-making in individual cases and in the aggregate. The example of importance here involved the behavior of gamblers. In essence, Kahneman found that changing the probability of a particular outcome, such as winning a lottery, does not lead to a commensurate change of behavior among participants. Indeed, it seems as if individuals undervalue opportunities that are near-certain, as the Fundsmith report attests:
"An increase in probability from 50-60% attracts an increase in decision weight of just six points. But an increase in probability from 90-100% attracts an increase in decision weight from 71 to 100% – a 29% increase or nearly five time the perceived worth of the rise from 50-60%."
That is interesting, and it should be fairly obvious that this behavior could have an impact on how people make investment decisions. But what sort of impact?
Undervaluing quality
In essence, Kahneman’s findings suggest that there is a major opportunity to exploit the clunky probability judgments of the crowd. Specifically, the fact that events with a high degree of certainty occurring tend to be undervalued has significant investment implications, as the Fundsmith report explains:
"This implies that near certainty will be undervalued. This is the world of low beta/high quality stocks. They have regular bond like returns and low share price volatility but they are still stocks with uncertainty about share price and dividend payments whereas bonds have the relative certainty of redemption values and coupons. This helps to explain why 'boring' quality stocks tend to be consistently under-valued, and that under valuation is what helps to produce superior performance as investors are offered the chance to purchase more return for the level of risk assumed than they should be. We are able to underpay for every unit of cash flow we get from those stocks compared with what it should cost us if investors priced certainty of return consistently."
In other words, investors thinking rationally should be able to identify value stocks with strong financials but that are undervalued by the fact that their returns are even slightly uncertain. A high-grade bond, especially the sovereign bond of a rich Western country like the U.S., Canada, Germany or the U.K. may be risk-free to a degree. But their returns are anemic. Meanwhile, the returns derived from a company with near-certain high performance are significantly higher thanks to the fact that even the small degree of uncertainty leads to their being undervalued.
Verdict
This is, in many ways, a classic case for value investing. Stocks that look staid and boring, but that generate consistent cash flow and grow at a healthy rate, can offer powerful upside over the long run. These sorts of stocks may never become hot commodities, by their nature and the nature of human psychology.
But as sources of value accretion and income generation, these types of deep value stocks may find no equal. The Fundsmith report’s parting advice is thus worth taking to heart:
"Rather than seeking superior portfolio performance by buying high risk stocks, investors should seek out 'boring' quality companies which have predictable returns and superior fundamental financial performance, and take advantage of their persistent."
Disclosure: I/We have no position in any stock discussed.
