Ideas Farm: the broken promises of containment

  • What happened to all these foreclosure winners?
  • … Oh my God! It’s horrible.
  • Some valuable lessons to learn.
  • Full of new ideas generating data.

The closures are taking effect once again in parts of Europe. But in the stock market, the lockdown seems like a distant memory for many stocks that were torched by the start of the pandemic.

In the United States, stocks in companies like the video conferencing company Zoom (US: ZM) and exercise bike company platoon (US: PTON) are below their highs of 65 percent and 73 percent, respectively.

Closer to Home, Online White Goods Retailer AO World (AO.) Is down 76% from its January peak. This spike follows a 767% rise from early 2020 to early 2021. Meanwhile, Best of the best (BOTB), a ball-to-win car competition operator, has fallen 83% since March. It recorded an almost 10-fold increase from early 2020 to its highest while amassing an army of private investor fans. And the list of stars fallen from confinement could grow … and grow.

What the hell happened?

The most likely answer is that we’ve just seen a pretty extreme case of deep-rooted human behavior at work. The behavior in question being our tendency to over-extrapolate very pronounced short-term trends. Our brains are extremely predisposed to do this.

Behavioral psychologist Daniel Kahneman, winner of the Nobel Prize, calls the multitude of psychological traits that engender such myopic reasoning as “What you see is all there is.” In essence, we find it very difficult to properly contextualize recent events that have attracted attention. We are sold on accounts suggesting that good performance can continue, and have the odd habit of finding supporting evidence while ignoring arguments to the contrary.

This puts investors in all kinds of trouble, especially when it comes to growth stocks. We assume that a short period of exceptional growth is indicative of the future when it is not. This is also often cited as a reason for the long term underperformance of the growth driven Aim market.

But there are two other aspects of our habit of misunderstanding growth trends that can help investors take advantage of psychological weaknesses rather than just trying to avoid losses.

When we come across real long-term growth trends, we actually tend to underestimate them. We believe that growth is linear rather than exponential. The great Swedish doctor and data visualization pioneer Hans Rosling described it as “the instinct of the straight line”.

In the real world, success often hinges on success. Profits of large companies tend to snowball, with annual growth leaning on a broader base. We get an upward curve rather than a straight line.

Entrepreneur and author Peter Diamamdis uses excellent thought experiment to demonstrate how mind-blowing this type of exponential growth is. Leaving our house and taking 30 “linear” steps of one meter from our front door takes us 30 meters. But taking 30 exponential steps, where our stride starts at one meter but doubles each step, would circle the planet 26 times.

Translate this concept into books rather than steps: Find a business with sustainable, high returns on capital and a real prospect of long-term growth, and it will more than likely be undervalued. That said, finding such a beast is extremely rare. And getting back to the point on Fallen Locking Stars, our flaw is being too ready to believe we’ve found the Legendary Beast while underestimating it if we actually do.

Perhaps the easiest way to profit from our tendency to misunderstand trends is the approach used by so-called value investors. Just as we believe the good news will never stop pouring in, when the news is bad our instinct is to think it always will be.

Sometimes instinct is right. However, with diligent research we can sometimes identify situations where there is hope for a better future that the market overlooks. Some of the lockdown hero stocks may be worth exploring from that perspective now.

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