Book Review: The Little Book of Behavioral Investing, by James Montier

Given that James Montier’s The Little Book of Behavioral Investing recently topped the list of bestselling business books in Canada, according to the Globe & Mail newspaper (August 30th), now seemed like a particularly good time to provide a full review. In his latest book, Montier provides an introduction to behavioral economics. He identifies a list of common emotional pitfalls in regards to how we invest money and proposes some safeguards against most if not all of them.

Montier starts by introducing our brains’ two main decision-making systems. The X-System, having appeared first, is the more developed and corresponds to emotional decision-making. It uses mental shortcuts and is quicker to activate. The C-System has only developed in humans over the past few centuries. It corresponds to logical thinking and usually takes more time to activate. People who tend to rely more on their C-System tend to make far better investors. However there are serious limitations to it. It comes in limited supply (those who habitually use it more tend to get more usage of it) and even if you use it, you can still fall prey to a number of biases and other problems. These are:

1) Over-optimism bias
2) Self-serving bias
3) Overconfidence, especially demonstrated by experts
4) Confirmatory bias
5) Conservatism bias, in that we hang on to our views too long
6) Action bias

Montier takes a strong stance against many of today’s common investment practices. This starts with forecasting, which he compares to trying to be one step ahead of everyone. This is put in direct contrast to analysis of the facts on hand and knowing generally where you stand in a cycle or trend. He rails against our seeming addiction to collecting more information, despite this having no positive effect on the results from our decision-making (though it sure raises our confidence in our otherwise faulty decisions). A number of counters, some very practical, are put forward. For example, Montier advocates the use of pre-commitments, such as pre-entered buy and sell orders, in order to deal with our inability to predict how we will react in the future (that’s called an empathy gap). Another one is to keep an investment diary detailing the why of each decision at the time it was taken.

Montier generally takes the approach of introducing a behavioural problem and how it applies in the general population, giving an example or two, and then he presents how it manifests itself in the investor or the investment manager or both before prescribing a potential counter. Often the experiments have interesting results and implications. For instance, it is documented (and not the first or the last time I’ve seen this) that women are better investors than men. In another, he compares the confidence levels of predictions made by weathermen versus doctors and their actual accuracy.

Compared with his previous book Value Investing and other investing books, this one presents a different kind of usefulness. For one thing, it barely qualifies as an investing book as it deals strictly with psychology. There aren’t any investing nuggets so to speak or great lessons or much else of immediate, obvious practicality. What it does offer however is ways to take a hard look at ourselves and how we make decisions. Depending on your style, The Little Book of Behavioral Investing probably won’t be a book you will refer to particularly often but one you’ll go back to periodically over longer periods of time.

Capella Education: pass or fail?

My latest investment idea, Capella Education, comes from the battered for-profit education sector. It is the parent company of Capella University, an online-only institution who’s clientele is comprised at 80% of professionals seeking graduate degrees and with an average age of 39. As per the usual cliché, the market tends to throw the baby out with the bathwater and I think this was the case here. Not to trivialize the concerns attributed to this sector for they were very real for the most part. To briefly recap, stocks in for-profit companies had increased substantially over the past few years as they became a popular alternative to traditional schools. They continued to rise during 2008 while the broad market tanked as the difficult economy gave a double incentive for people to go back to school in the form of more free time and the necessity to compete for fewer jobs. But in 2009-10, the situation reversed dramatically: as the markets roared back, education stocks as a whole were falling badly. Part of it was a much needed cooling off period after an extended growth run, as education stocks had traded at hefty valuations previously. But for the most part, it was because the industry as a whole was in turmoil.

As it turns out, the value that the sector brings was being called into question. The US Government Accountability Office released a report detailing its investigation into questionable recruitment tactics, going from misrepresenting employment prospects and financial aid eligibility to encouraging outright fraud. Also in the spotlight have been attempts by for-profits to recruit within homeless shelters. A far larger proportion of students go into default than in traditional institutions. At the same time, many former students complain that they haven’t been able to find meaningful employment in their field following graduation, if they graduate at all for in that respect also the numbers are significantly worse than in traditional colleges. This is largely reminiscent of a similar rough patch for the industry in the late 80s, when various allegations of fraud and other dubious practices led to restrictions on access to federal funding for students of these institutions. These reforms had been partly undone by the Bush administration, therefore enrollment soared and stock prices along with them in the past decade.

Now, there is scrutiny on the for-profit sector and the Department of Education had been working on changing the rules that govern whether a student that goes to these institutions can receive federal aid. Ostensibly, if a prospective student cannot get funding from attending a certain institution, then they would not be interested in that institution. This would effectively kill the business. On June 2nd, 2011, the Department of Education added a rule on "gainful employment" to the existing rules that determined eligibility to federal funds. All interested observers had been awaiting the official announcement on the gainful employment rule for a long time now, hence the uncertainty around the sector for the last while. All in all, and in spite of most of the industry’s protests to the contrary, the new criteria proved to be much weaker than previously anticipated and so for profit stocks had a nice bounce in the aftermath. But as much as the entire sector had been oversold previously, plenty of otherwise weak companies have recovered to the same extent as their stronger peers. Buying in a distressed sector is an almost universally sound way of turning up very profitable investment. However the important idea is to choose wisely within that sector, not buy blindly whatever pops up. A casual reading of news concerning the for-profit industry will turn up more or less the same names mentioned negatively and another set of names positively.

Here are the 3 main rules affecting eligibility to federal funds:
1) Gainful Employment. There are 3 subtests to this general criteria: A) At least 35% of former students are repaying their loans, or B) Estimated annual loan payment of a typical graduate must not be bigger than 30% of his or her discretionary income, or C) Estimated annual loan payment of a typical graduate must not be bigger than 12% of his or her total income. This rule won’t take effect until 2015.
2) 3-year cohort default. Modified from its prior version in 2009, this is the proportion of students in a cohort taking debt who default 3 years after leaving school. An institution can have its eligibility in jeopardy if its 3-year default rate is 25% or more for 3 consecutive years.
3) The “90/10” rule. An institution cannot derive more than 90% of its cash sales from Title IV federal funds for 2 consecutive years.

The Department of Education estimates that only 5% of all programs offered by for-profit organizations will be affected, the precise amount probably varying from one company to the next. Nevertheless, having only until 2015 to comply, the date is far enough that at least some organizations can adjust so this is not a concern for the most part. The latest numbers on 3-year cohort default rate, though available for the most part in annual reports, can also be conveniently found at the level of the industry here. Compliance with the 90/10 rule should be available in the financial statements.

In short, some companies indeed standout very much from the rest, both in the news (some mostly for not being mentioned in the news in the first place) and in the metrics. There are 3 that I was particularly looking into: Strayer, Devry and Capella. Devry’s showing in regards to the 90/10 rule was exemplary, at least for a for-profit organization (74% of revenue from federal funds according to its 2010 annual report) but I do not like that the 3-year cohort default for 2008 was 20%, not bad but far from stellar either. Strayer clocks in at 14% and Capella only 8%. Both Strayer (latest figures are of 2009) and Capella have 78% of their revenues provided by federal funds so they are far enough from the 90% threshold for it to be a concern. Overall they all have similar business risk profiles (i.e. relatively little) with Devry probably slightly less good. As a measure of financial analysis, their respective Piotroski F-scores are all excellent. However, I give preference to Capella due to its much stronger balance sheet compared the others. Its current ratio is above 5 and, at its current price, cash and equivalents represents well over a quarter of the market cap of the company. It also happens to trade at barely 10X its (adjusted) free cash flow so from a valuation perspective it is definitely very attractive. By comparison, Devry is both expensive and has quite a bit less protection on its balance sheet. Strayer is about as cheap as Capella but its leverage has been going steadily up for a number of years and it also doesn’t have much protection left in the form of a solid current ratio. Capella, at current prices of around $43-44, offers the most protection both on the balance sheet and from a valuation perspective.

Disclosure: Konrad does not own any of the securities mentioned in this article.

Book Review: Value Investing: Tools and Techniques for Intelligent Investment, by James Montier

Value Investing: Tools and Techniques for Intelligent Investment is at its heart a gathering of James Montier's recent online writings. For his online followers, most of the material here has been touched upon and is, for the most part, reprinted here with little modification. However there a number of new additions, most notably on the recent financial crisis. Mr. Montier, of British origin and previously from Société Générale, now plies his trade at GMO, a value investment firm with a quantitative orientation. Perhaps not surprisingly, Value Investing is a book heavy on stats and graphs from various experiments and research. Apart from those graphs demonstrating value investing results and the pitfalls of investing in general, the most interesting of the research cited in the book chronicle various human weaknesses, often at first seeming unrelated to finance, and how they contribute to our lower performance on the stock market. These include, among others, overconfidence, obsession with excessive information, and tendency to extrapolate recent trends into the future. Generally speaking, not surprisingly given that he authored three other books on the topic (Behavioural Investing: A Practitioners Guide to Applying Behavioural Finance
, The Little Book of Behavioral Investing: How not to be your own worst enemy
and Behavioural Finance: Insights into Irrational Minds and Markets
), Mr. Montier believes, and I tend to agree, that most of our investment failings are due to psychological factors.

Not that actual investment methods are faultless in all of this. Mr. Montier takes an axe to today's investment teachings revolving around the Efficient Market Hyphothesis and most of its assumptions. The first part of the book explores EMH's implications, logical incoherence and empirical results. Amongst other things, for instance, low beta stocks are shown to outperform high beta stocks, which is the exact opposite of theory. Mr. Montier also explores the shortcomings of Discounted Cash Flow models and the inability of analysts' to forecast, and others.

A few alternatives are offered throughout the book, such as the use of the "Graham-and-Dodd PE", the Piotroski score, using reverse-engineered DCF to analyze the implied assumptions behind current prices, guarding against business and financial risks, etc. In what is probably the most interesting part of the book, Mr. Montier proposes some tests to identify short candidates. While I myself have no interest in shorting, it does give a suggestion on stocks to avoid. In all most if not all cases, these involved quantitative measures. While these don't occupy the majority of the book, which clocks in at well over 300 pages, Mr. Montier goes well enough in the detail of their reasoning and results for the book to merit the "Tools and Techniques" part of the title.

The text isn't without flaws. One thing that might grate some readers is how vitriolic Mr. Montier is in pointing the weaknesses of current investment theory and practices. Not that his points aren't valid, quite the contrary, but it's hard not to get distracted by his sometimes acidic tone. Another criticism is that, while there are plenty of quantitative tools suggested, this book doesn't give any clue whatsoever how to approach the qualitative features of stocks. That said, some value investors are far more, if not exclusively, concerned with the numbers in the financial statements as opposed to doing a business analysis, and most analysis can probably be quantified, but the omission of this topic is noticeable and a huge disappointment. Perhaps the biggest criticism one can address to this book is the format. As mentioned previously, most of Value Investing consists of reprinted material from Mr Montier's online postings over the past few years, with some updates. Readers and non-readers of his blog would probably feel offended at paying for something that is free online. But I think this is a moot point. Rehashed ot not, there's is far too much material to make revisiting Mr. Montier's online postings an easy task. If anything, having them all regrouped in one tome makes far more convenient to revisit them (for my part, I've read the book 2 times from start to finish so far, while revisiting specific sections numerous other times). That said, the format does make the text disjointed. Perhaps more time should've been spent rewriting and editing the postings so they fit each other more, rather than making it seem like an obvious copy and paste job.

Nonetheless, Mr Montier's Value Investing is certainly a highly practical book and very actionable. The most important thing to take away from this book, and a recurring theme in all of Mr. Montier's writings, is that investing is more psychological than anything else. Entertaining and with interesting implications, I highly recommend this book. I plan to come with a review of Mr. Montier's follow up, the Little Book of Behavioral Investing, some time soon.

What goes up...? Momentum in investing

A recent article in The Economist newspaper, entitled "Why Newton Was Wrong", explores the effect of momentum in investing. Several studies, presented in the article, have all demonstrated that picking the best performing stocks from the previous 12 months would provide market-beating results. Moreover, this momentum effect exists for other securities markets, such as commodities and currencies, and has been observed for decades.

While several other stock market "anomalies" have been observed and then disappeared due to exposure, the persistence of the momentum effect had been a mystery. Nonetheless, the Economist puts forth possible explanations. Namely, the momentum effect may represent a lag between the perception of companies and their actual results. When investors have a negative view of a business, they tend to dismiss positive news about it as a blip. Then when the good news continues, they pile into the stock. Moreover, the effect may be carried over as fund managers proceed with "window-dressing" their portfolios by buying securities that had recently gone up, thus contributing to further boost stem.

Momentum strategies have been devised over the past to exploit the effect. These strategies have grown more complex, sometimes involving trading at incredible speeds. However that has made some of those strategies vulnerable to random movements in the markets. Moreover, momentum investing, over long time periods, loses out to value investing as prices of unfavored securities are driven down to bargain territory. It is noted that momentum investing has tended to misfire horribly at times and the article muses that the strategy may be behind  the creation and maintaining of asset price bubbles. Some of this was not necessarily unknown in value investing circles. In its "What Has Worked In Investing" paper, noted value investing firm Tweedy Browne cites studies that point out how value investing outperforms momentum investing over periods longer than 12 months. Some of this had also been reprinted in "The Little Book of Value Investing" by the late Christopher Browne, former director at Tweedy Browne.

Why Value?

I figure the first subject to explore is why am I doing this blog and how I came about upon value investing. It took me a somewhat elongated route to get there, though not necessarily a convoluted one, just long. In hindsight the signs were probably there somewhat. I wasn't raised with a background in finance or business or the like. Even in my extended family it's not a reoccurring interest, and this also wasn't a topic that was discussed much, if ever. Nonetheless, as far back as my early teens when I started getting interested in reading newspapers, I was immediately drawn to the business section. Mind you, like any hockey-loving teen, nothing took precedence over the sports section but business quickly became another favorite as I became interested in what companies did, how they made money and how the stock market functioned.


My first stock pick was in my first economics class, in high school, at 15. It was in Biochem Pharma, a medium sized Canadian pharmaceuticals.  Back then I had no concept of investing, reading financial results or what not, I merely picked that company because it had popped up quite a few times in the news, usually with good news. Then I watched the stock price go down more or less continuously as the company was then appearing in the press but with bad news. (Not much later, Biochem Pharma ended up being absorbed into Shire PLC, of the UK).


In spite of this inauspicious start to an investing career, I was not deterred from doing some more research into the investment industry. I graduated from university with a bachelor's degree in business administration. There I first became aware of the securities analyst profession. At the same I did a lot of reading on investing and the stock market. Early on, I found that the Value investing philosophy made the most sense to me. The most logical way of investing is to buy a stock trades beneath its value, not on what it may or may not do next quarter. Furthermore stocks are more than just symbols to play around with like a lottery, they represent ownership in a real business. Therefore the soundest way to approach investing is through the view of a business owner.

I now spend a lot of my free time reading. There's a lot of interesting books on the subject of value investing and its approaches. I also dedicate time to perusing the financial statements of companies that might interest me, both for my own real portfolio, as well as for my electronic portfolio, which will only include businesses after I have researched. You can only better at things by practicing and I intend to accumulate lots of experience. The goal of this blog is therefore to gain experience by chronicling my own reflections on investing, my picks and recommendations, as well as presenting business and investing news that I find particularly interesting. Thus far I have a bit over 2 years experience at investing and I'm looking forward to learning more and refining my style. Professionally, I'd love to get into security analysis or portfolio management as a career as I find it fun to learn about different businesses and I'm currently studying to obtain the CFA designation. I don't expect all my decisions to be home runs and like any good investor I expect to see some losers but this is a thoroughly enjoyable interest and I hope everyone can enjoy and benefit alongside me.