Friday, February 17, 2012

Aeropostale (ARO): Part Three - A Behavioral Finance Case Study

In valuing Aeropostale in the previous post, we built an ugly scenario that assumed ARO's operating performance deteriorated significantly. I suggested that, were this to occur, the market would punish the shares through a broad sell-off that could easily push its price down by 50 to 60 percent from the current $18 level.

This is pretty much what happened in October 2011. After years of growing same store sales quarter after quarter in an unblemished winning streak, ARO went into a slide for several consecutive periods. Same store sales were declining, inventory wasn't moving, gross margins were taking a hit, and it was clear that another winning streak was at risk...growth in earnings per share.

Investors stuck with ARO through the first couple misses. Management deserved some leash, they had demonstrated a lot of success with this business model over the years. But from the spring of 2011 through the autumn, the one-time darling was quickly becoming a toad. The stock price plummeted from $26 per share to a multi-year low of $9.16. Even the most stalwart supporters were losing their resolve - irrespective of their views of the long-term business prospects - as they saw their holding value collapse by two-thirds. While they may have reached the same conclusions about the business as I did in my original post (here), few could stomach being part of a quick fall and then trudge through a recovery that would likely take many quarters if not years.   

For a construct to understand the dynamics of that sell-off, and the resulting opportunity to buy into a good business at a cheap price, I turn to the field of behavioral finance and Harvard economist  Andre Shleifer. 

In his book Inefficient Markets: An Introduction to Behavioral Finance, Shleifer builds on the work of Robert Shiller and Richard Thaler, pioneers in this burgeoning field that blends theory from economics and psychology. 

Considered simplistically, behavioral economics is a rebuttal of efficient market theory dogma...that belief in investors as rational agents using all available information to make rational decisions in a stock market that is thereby efficiently priced at any given moment. Nonsense, says the behavioralists. The market is an amalgamation of individual decision makers, the choices of whom are as influenced by whim, fear, and optimism we all experience as human creatures with emotionally-charged minds.

I picked up this book in spring 2008 and was immediately intrigued by Shleifer's use of basic psychology to theorize why strings of over-performance or under-performance by companies tend to lead to corresponding over- and under-valuations by investors. Allow me to frame the ideas with this long quote from the author: 
"When a company has a consistent history of earnings growth over several years, accompanied as it may be by salient and enthusiastic descriptions of its products by management, investors might conclude that the past history is representative of an underlying earnings growth potential. While a consistent pattern of earnings growth might be nothing more than a random draw for a few lucky firms, investors see 'order in chaos' and infer...that the firm belongs to a small and distinct population of firms whose earnings just keep growing. 
"As a consequence, investors using the representativeness heuristic might disregard the reality that a history of high earnings growth is unlikely to repeat itself, over-value the company, and become disappointed in the future when the forecasted earnings growth fails to materialize. This is, of course, what overreaction is all about." 
What forces might be at play that would allow this over- and under-valuation to occur? Shleifer turns to three heuristics from social psychology for explanation.

The first is REPRESENTATIVENESS. As social psychologists Tversky and Kahneman demonstrated long ago, people have the tendency to believe they see patterns in truly random sequences. We see consecutive quarters of earnings growth, and our mind convinces itself that this is a pattern that will continue into the future. Likewise, we see earnings drop and our minds create a future in which they just continue dropping. Though the events that caused the drop might be temporary (or even random), the human mind begins to see patterns that affect the valuation we assign to a business. In Shleifer's words:
"...when investors are hit over the head repeatedly with similar news - such as good earnings surprises - they not only give up their old model but, because of representativeness, attach themselves to a new model in which earnings trend. In doing so they underestimate the likelihood that the past few positive surprises are the result of chance rather than of a new regime."
Once we establish a model in our minds that the business is trending up or down, we run into the second heuristic, CONSERVATISM...

"...when [investors] receive earnings news about this company, they tend not to react to this news in revaluing the company as much as Bayesian statistics warrants, because they exhibit conservatism. This behavior gives rise to underreaction of prices to earnings announcements and to short horizon trends."
In other words, when we have an opinion, we tend to be protective of it, sticking to it for a while despite disconfirming evidence that should probably cause us to change our minds. In fact, Shleifer notes, it usually takes two to five pieces of evidence that are contrary to our opinion to get us to change our minds. 

But once our minds are changed, the third heuristic comes into play, OVERREACTION. Back to Shleifer...

"...over longer horizons of perhaps three to five years, security prices overreact to consistent patterns of news pointing in the same direction. That is, securities that have a long record of good news tend to become overpriced and have low average returns afterwards. Securities with strings of good performance, however measured, receive extremely high valuations, and these valuations, on average, return to the mean."
And the same is true vice-versa for bad news. In a nutshell, we witness a few events (either positive or negative) and our minds infer a pattern, believing that a trend has been established (representativeness). We interpret the trend and place our bets, sticking to our guns even in the face of initial evidence that our opinion is incorrect (conservativeness). Finally, after several instances of disconfirming evidence we do change our minds, but we do so in a way that pushes us to over- or under-value the company in question (overreaction). 

As any good economist, Shleifer then sets about proving his theory by going to the data and drawing on statistical models with greek symbols and formulas that escape my grasp. But he manages to conclude that, at any given time, the stock market is full of companies that are over- or under-valued based on overreaction to consecutive earnings surprises that stoked euphoria in buyers or panic in sellers. An investor would do well, he concludes, buying the extreme losers from this phenomena and staying away from the extreme winners.

Sounds like an interesting model to lay on top of what we've seen with Aeropostale over the past several months. In the next post, we'll do just that.  

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