One of the benefits of writing regular articles is the ability to go back and review your predictions and recommendations and see how things ultimately end up. Sometimes you can look back with a certain amount of pride (like our recommendation to be aggressive buyers in the 2008/2009 Great Recession), but most of the time these things seem to come back and haunt us for the remainder of our careers (for such a truly horrendous example please read our article “Lessons We Have Learned” which can be found here)[1]. Unlike many politicians who live by L.P. Hartley’s dictum “The past is a foreign country: they do things differently there”, at Nintai we are quite comfortable looking back at our historical musings and measuring our performance. Sometimes right, sometimes wrong, there is always something to be learned.
Revisiting the Overreaction Hypothesis
With that said, earlier this year I wrote about the “Overreaction Hypothesis” in which violent movements - both up and down - in individual equity prices are usually matched by an equal and opposite response (the article can be read here). This concept was first proposed by Richard Thaler and Werner De Bondt in their seminal work "Does the Stock a Market Overreact?". In their article[2], Thaler and De Bondt stated:
“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:
The Overreaction: SolarWinds
In the article, I used SolarWinds (SWI) as a potential example of overreaction hypothesis. As background, on July 17th, SWI’s 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). 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. Utilizing a DCF model, management’s revised earnings estimates reduced our estimated intrinsic value by less than 2% ($54/share revised down to $53/share) yet Mr. Market would have us believe the company was worth roughly one-quarter less than the day before[3].
Testing the Hypothesis
According to Thaler and De Bondt, there are three (3) effects that will ultimately inform us about both the overreaction as well as the counteraction to take place in the future. These include:
Directional Effect: Extreme movements in equity prices will be followed by movements in opposite direction. According to this effect, we would see an extreme movement to the upside after such a drop in price.
Magnitude Effect: The more extreme the initial price change, the more extreme the offsetting reaction. In this case, we should not only see an upward price move, but a move of significant magnitude since the drop was nearly 25%.
Intensity Effect: The shorter the duration of the initial price change, the more extreme the subsequent response. Since the drop occurred in a singly day, we should see a dramatic move occurring in a very compressed amount of time.
In essence, Thaler and De Bondt argue that after SWI’s 25% price swoon on July 20th, the markets should produce a swift, massive upward price surge.
So how did their model work out? After dropping from $47/share to roughly $36/share on July 17th, the stock slowly rose to $41.50 through October 8th. On October 9th the stock jumped nearly 14% after the Board announced they were exploring strategic options including the possibility of an LBO or acquisition. Talk on the Street has mentioned discussions with PE firms and a sale price of roughly $55-$60/share.
In this instance, Thaler/De Bondt’s hypothesis of a rapid, substantial, and upward price move has taken place. As owners, we couldn’t be more pleased that Wall Street recognizes the value of the company.
Possible Reasons for the Overreaction Hypothesis
So do the data guarantee an equal and proportional response for every sharp price movement? No. But Thaler/De Bondt’s research does show that it happens often enough that we can make some general observations going forward. First, we can assume a considerable price movement gets enough animal spirits moving that we can see roughly correlative reactions to the initial actions. Second, these animal spirits are often driven by emotions rather than sound qualitative thinking. This puts the basis for these market reactions less about data and more about passion. Last, profound price changes can provide incentives for varying types of investors. A significant drop may produce interest in activist hedge fund players. So it shouldn't be that surprising when market reactions frequently counteract a significant pricing event.
That said, I would posit there are several conditions that might enhance an investor’s chances of achieving positive results from such dramatic price moves.
Price Movements Push Valuation Extremes: In the case of SWI, the dramatic drop in price pushed the stock’s valuation into highly undervalued territory. We think investors would be rewarded most when the price action pushes valuations into highly over or undervalued territory. These valuations would greatly enhance the chance of Mr. Market making a strong counter move.
Quality Can Impact Your Outlook/Position: We believe investors would be wise to look for sudden downward price moves with high quality companies (in this case go long) or the opposite for low quality stocks (short the stock after sudden upward price moves). In the case of SWI, we believe the market saw a high quality company trading at a very low price – hence the surge upwards.
Always, Always Focus on Valuation: Ultimately investors have no idea about the catalyst in the Overreaction Hypothesis. As value investors we are best to focus on the impact of the sudden price move on valuation, and ultimately let the chips fall where they may. In the final analysis, we believe Nintai’s investment in SWI will ultimately work out because we purchased a piece of a business at a significant discount to fair value.
Conclusions
Thaler and De Bondt’s research has stood the test of time since they first published roughly 30 years ago. Data tell us we can expect – in general – a reaction similar to our experience with SolarWinds. Whenever we see a case of the Overreaction Hypothesis we take a long hard look at the company, the reasons behind the pricing event, and the relationship between the new price and estimated fair value. While I never assume we will see a reaction as outlined by Thaler et al, we certainly are aware it could happen. Watching SolarWinds work out as an Overreaction Hypothesis candidate has been great to watch. Unlike my call on Michael Jackson, I might just come out ahead on this one. And that's something I won’t complain about.
[1] Another classic ill-made prediction was my statement in 1978 that Michael Jackson was clearly going to flame out and have no impact on the music industry. How I reached this conclusion is beyond me, but I am reminded every so often (in a remarkably joyful manner) by friends and family.
[2] “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
[3] On July 20th, 2015 the Nintai Charitable Trust initiated a substantial long position in SWI at roughly $36/share.
Revisiting the Overreaction Hypothesis
With that said, earlier this year I wrote about the “Overreaction Hypothesis” in which violent movements - both up and down - in individual equity prices are usually matched by an equal and opposite response (the article can be read here). This concept was first proposed by Richard Thaler and Werner De Bondt in their seminal work "Does the Stock a Market Overreact?". In their article[2], Thaler and De Bondt stated:
“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:
- Extreme movements in stock prices will be followed by subsequent price movements in the opposite direction.
- The more extreme the initial price movement, the greater will be the subsequent adjustment”.
The Overreaction: SolarWinds
In the article, I used SolarWinds (SWI) as a potential example of overreaction hypothesis. As background, on July 17th, SWI’s 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). 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. Utilizing a DCF model, management’s revised earnings estimates reduced our estimated intrinsic value by less than 2% ($54/share revised down to $53/share) yet Mr. Market would have us believe the company was worth roughly one-quarter less than the day before[3].
Testing the Hypothesis
According to Thaler and De Bondt, there are three (3) effects that will ultimately inform us about both the overreaction as well as the counteraction to take place in the future. These include:
Directional Effect: Extreme movements in equity prices will be followed by movements in opposite direction. According to this effect, we would see an extreme movement to the upside after such a drop in price.
Magnitude Effect: The more extreme the initial price change, the more extreme the offsetting reaction. In this case, we should not only see an upward price move, but a move of significant magnitude since the drop was nearly 25%.
Intensity Effect: The shorter the duration of the initial price change, the more extreme the subsequent response. Since the drop occurred in a singly day, we should see a dramatic move occurring in a very compressed amount of time.
In essence, Thaler and De Bondt argue that after SWI’s 25% price swoon on July 20th, the markets should produce a swift, massive upward price surge.
So how did their model work out? After dropping from $47/share to roughly $36/share on July 17th, the stock slowly rose to $41.50 through October 8th. On October 9th the stock jumped nearly 14% after the Board announced they were exploring strategic options including the possibility of an LBO or acquisition. Talk on the Street has mentioned discussions with PE firms and a sale price of roughly $55-$60/share.
In this instance, Thaler/De Bondt’s hypothesis of a rapid, substantial, and upward price move has taken place. As owners, we couldn’t be more pleased that Wall Street recognizes the value of the company.
Possible Reasons for the Overreaction Hypothesis
So do the data guarantee an equal and proportional response for every sharp price movement? No. But Thaler/De Bondt’s research does show that it happens often enough that we can make some general observations going forward. First, we can assume a considerable price movement gets enough animal spirits moving that we can see roughly correlative reactions to the initial actions. Second, these animal spirits are often driven by emotions rather than sound qualitative thinking. This puts the basis for these market reactions less about data and more about passion. Last, profound price changes can provide incentives for varying types of investors. A significant drop may produce interest in activist hedge fund players. So it shouldn't be that surprising when market reactions frequently counteract a significant pricing event.
That said, I would posit there are several conditions that might enhance an investor’s chances of achieving positive results from such dramatic price moves.
Price Movements Push Valuation Extremes: In the case of SWI, the dramatic drop in price pushed the stock’s valuation into highly undervalued territory. We think investors would be rewarded most when the price action pushes valuations into highly over or undervalued territory. These valuations would greatly enhance the chance of Mr. Market making a strong counter move.
Quality Can Impact Your Outlook/Position: We believe investors would be wise to look for sudden downward price moves with high quality companies (in this case go long) or the opposite for low quality stocks (short the stock after sudden upward price moves). In the case of SWI, we believe the market saw a high quality company trading at a very low price – hence the surge upwards.
Always, Always Focus on Valuation: Ultimately investors have no idea about the catalyst in the Overreaction Hypothesis. As value investors we are best to focus on the impact of the sudden price move on valuation, and ultimately let the chips fall where they may. In the final analysis, we believe Nintai’s investment in SWI will ultimately work out because we purchased a piece of a business at a significant discount to fair value.
Conclusions
Thaler and De Bondt’s research has stood the test of time since they first published roughly 30 years ago. Data tell us we can expect – in general – a reaction similar to our experience with SolarWinds. Whenever we see a case of the Overreaction Hypothesis we take a long hard look at the company, the reasons behind the pricing event, and the relationship between the new price and estimated fair value. While I never assume we will see a reaction as outlined by Thaler et al, we certainly are aware it could happen. Watching SolarWinds work out as an Overreaction Hypothesis candidate has been great to watch. Unlike my call on Michael Jackson, I might just come out ahead on this one. And that's something I won’t complain about.
[1] Another classic ill-made prediction was my statement in 1978 that Michael Jackson was clearly going to flame out and have no impact on the music industry. How I reached this conclusion is beyond me, but I am reminded every so often (in a remarkably joyful manner) by friends and family.
[2] “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
[3] On July 20th, 2015 the Nintai Charitable Trust initiated a substantial long position in SWI at roughly $36/share.
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