We started off this mini-series by looking at Professor Bruce Greenwald’s thoughts from a lecture at the Gabelli Value Investing Conference on the investment process, and in particular, on the importance of sticking to small, boring companies and markets. In the same lecture, Greenwald went on to discuss why institutions seem to crowd into the same narrow group of stocks.
Institutional bias
“There are institutional reasons that money managers are likely to concentrate in certain kinds of stocks which will lead those stocks to be overbought and overvalued and to therefore concentrate away from other types of stocks that will be underbought and undervalued. Once that process starts, by the way, there is strong institutional reinforcement. You get in trouble as an institutional money manager by significantly deviating from the performance of other institutional money managers. If you just or match the performance of other money managers, you are not going to get into trouble. What is the way to do that? It is to buy whatever everybody else is buying”.
Right out of the gate, Greenwald identifies a central problem for money managers. The fear of posting a significantly worse record than their industry peers leads institutions to accumulate positions in the same stocks. This crowding effect was arguably one of the main reasons for the great bull rally in the FAANG stocks -- for much of 2018, "long FAANG" was the most crowded trade on Wall Street.
“That again is behavior which leads to concentration in some stocks and away from concentration in others. There are also institutional reasons to concentrate on stocks that have huge potential upside. When you do your marketing, it helps to be able to say “we bought Microsoft in 1990 or we bought Cisco at the IPO in 1992” or whatever are the particular events. And anybody, who has listened to marketing presentations by institutional money managers, they talk about particular successes.
There is also a less respectable reason why they want to invest in that. If I’m a money manager, my compensation is an option. If the stocks in my portfolio go way up, I get paid a lot. If they go way down, it is very hard, especially when I am starting out for them to take the money away. So I have a big incentive to embrace risks with large upsides but perhaps steady downsides because if it’s a good year I do really well, if it’s a bad year, I don’t get punished. Those tend to be the big glamour stocks that have the capacity to triple, even if the expected return is only five percent as opposed to the stocks that, on average, will do better but don’t have that dramatic upside potential. So there are institutional reasons why we think concentration in high growth, high price-earnings glamour stocks is likely to continue”.
In other words, this behavior is rational (albeit sometimes unscrupulous) on behalf of individual money managers, but when all of them are doing it, the individual actions compound and make it so that some stocks are grossly overvalued (glamour tech stocks) and some are correspondingly undervalued (boring industrials).
For the reasons explained by Greenwald, is a phenomenon that is hard-wired into the current system, and as such, there will always be opportunities for value investors to profit from these mismatched between price and value.
Disclosure: The author owns no stocks mentioned.
