Tuesday, April 17, 2012

The Shleifer Effect Watchlist

Over the past few weeks I've begun working on some screens to help identify businesses experiencing some element of what I've come to call the "Shleifer Effect." In short, these are companies that have produced a string of results below investor and/or market expectations. The impact is a shift in current owners' expectations for future results (i.e., the trend will continue and the future will look like a worse version of the present) which produces an OVERREACTION in the form of a heavy sell-off and price drop. 

I'm really looking for two things. 

First, if I can uncover opportunities where the Shleifer Effect is already in play, that's the best. This is where the bad news is out in the open and the price has already been hammered over successive earnings reports. The overreaction had already set in and current investors have either stuck with it despite all the bad news (true long-term owners), or they've purchased their shares with the bad news in the open which potentially moderates their expectations of upcoming results.

Second, I'm trying to identify opportunities with developing Shleifer Effects. In other words, there is initial bad news/results but not yet enough to change investors' perception of the business and create an overreaction. I'll watch these to see how the market reacts as one earnings miss turns into two...three...four.

An important note: though these descriptions, and the use of charts, makes this seem like technical analysis, this is not really about timing a bottom. I'm still looking for good or great businesses whose models I understand (or can learn quickly) and whose economics are usually relatively stable...just not at the moment.  My ideal is to find an excellent business (a la Amazon.com, Costco, etc.) with clear competitive advantages and buy them as long-term holdings when the market punishes them for short-term outcomes. But I'm also open to investing in decent businesses (see Aeropostale) as medium-term (up to five years) when investors have overreacted in such a way that I can see a clear and conservative path to 15 percent annual returns with very little risk.

As discussed in this previous post about Thomson Reuters, using the Shleifer Effect as an investment screening strategy is about, as much as anything, interpretation arbitrage opportunities that can lead to time arbitrage opportunities.*

So, with that, I'll begin tracking existing and developing Shleifer Effect investment opportunities here. There is also a link on the blog homepage to see the spreadsheet.


*From the Thomson Reuters post referenced above:

Interpretation Arbitrage: Investors have interpreted declining earnings - and the resulting earnings misses - as bad news and reacted accordingly by changing their opinions on the firm's future and selling off shares. They've misinterpreted the financial information or news, creating an "interpretation arbitrage" opportunity.

Sometimes the EPS miss does not represent a change in the company's prospects. It can be random. It can be part of the grittiness of operating a business where you're just going to have down periods from time to time. Or (my favorite) it can be the result of management investing heavily in their advantages or best growth opportunities, driving up expenses faster than revenue can follow.

Time Arbitrage: Investors have witnessed declining earnings, correctly interpreted the results as temporary, but determined other investors will likely sell-off as a result, decided their own investing timeline is not long enough to wait it out, and so sell their holdings.

The business will be fine, and these owners have probably reached that same conclusion. But they must please their own investors this week, month, quarter, or year. The bad news might lead to several quarters or even a few years of depressed prices. The time arbitrage opportunity exists for anyone with the stomach and holding horizon to stick it out for the long-term gains.

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