Our team recently circulated an article from the CFA Institute Magazine called “The Next Paradigm”, which discusses some important behavioral finance aspects we incorporate in our thinking. The article caught our attention because of C. Thomas Howard’s track record and objective approach. Howard has compounded at almost 25% per year for the past 12 years with a concentrated portfolio, yet knows very little qualitative information about the companies he owns. Howard doesn’t follow news on his holdings and can’t even name some of them. He only looks for five things: a dividend (preferably high and growing), low forward P/E on consensus estimates, a high debt load, a low price/sales ratio and a minimum sales threshold.
So, Howard looks for stock attributes that appear correlated with outperformance. This is what Nobel-prize-winner Daniel Kahneman calls the “outside view,” or forecasting based on categories or “reference classes.” Howard then forgets the names of the stocks he buys to drive emotion out of his process. Many investors do the opposite – they let near-term results and emotion influence both their forecasts and their buy/sell decisions, often at exactly the wrong time and with sub-optimal results. We attempt to profit from these tendencies. Bill Miller said it best in a 3Q 2006 letter: “In markets, competitive advantages are three: informational, analytical and behavioral…Behavioral advantages are the most interesting because they are the most durable…” (Oct 2006).