Fooled By Randomness and Shleifer Effect

In this my third reading of Taleb's Fooled By Randomness in the past five years, my attention is drawn to a section he calls The Earnings Season: Fooled by the Results. Its description (below) is reminiscent of (or prescient of) the Shleifer Effect. It creates interesting questions about the model and how/whether it's tied to randomness.

First, allow me this point: The human brain works in funny ways. I make no claim that the Shleifer Effect is original in any way. I've already conceded (here) that its purpose is as a construct is to help me synthesize overlapping ideas gleaned from Benjamin Graham, Sir John Templeton, and Joel Greenblatt. And though I have no conscious recollection of this section from Taleb's book, I would assume his thoughts have influenced the Shleifer Effect as well.

From pages 164-5:

Wall Street analysts, in general, are trained to find the accounting tricks that companies use to hide their earnings. They tend to (occasionally) beat the companies at that game. But they are neither trained to reflect nor to deal with randomness (nor to understand the limitations of their methods by introspecting - stock analysts have both a worse record and higher idea of their past performance than weather forecasters). When a company shows an increase in earnings once, it draws no immediate attention. Twice, and the name starts showing up on computer screens. Three times, and the company will merit some buy recommendation. 

Just as with the track record problem, consider a cohort of 10,000 companies that are assumed on average to barely return the risk-free rate (i.e., Treasury bonds). They engage in all forms of volatile business. At the end of the first year, we will have 5,000 "star" companies showing an increase in profits (assuming no inflation), and 5,000 "dogs." After three years, we will have 1,250 "stars." The stock review committee at the investment house will give your broker their names as "strong buys." He will leave a voice message that he has a hot recommendation that necessitates immediate action. You will be e-mailed a long list of names. You will buy one or two of them. Meanwhile, the manager in charge of your 401(k) retirement plan will be acquiring the entire list.

Second, in terms of the Shleifer Effect and randomness, it begs some consideration. In his book Inefficient Markets, Andrei Shleifer's assumption seems to be that chance determines whether a company's earnings go up or down. He does not concern himself with competitive advantages protecting profits. He is digging through data, and his statistical models (in an attempt to make predictions) cannot spot any sort of rule that demonstrates whether earnings will go up or down for a given business in a given quarter.  So it is chance. 

I don't think that's his ultimate point, but it needs to be out there whether or not you agree with it. (I do, but only to a degree.)  The interesting part becomes the investor psychology in reacting to what might just be noise or random fluctuations in earnings results. The pattern-seeking human mind wants so badly to find order in the chaos, that we will invent a trend at the slightest hint of its presence. Even if the trend is no more than the chance outcome of random events.

That's Taleb's point here, too. I think. He constructs his cohort of 10,000 companies that "engage in all forms of volatile business." Perhaps I'm reading to much into it (or am so desperate to think that Taleb would find common philosophical ground with my own construct), but I make a distinction between a volatile business and one whose earnings are protected by some sort of competitive advantage. 

Either way, the outcome seems to be the same. You get one, two, or three actions moving in the same direction, and people begin seeing patterns. Analysts begin predicting more of the same in the future. Investors start buying in. The result is Shleifer's predicted overreaction. And it happens on the upside and the downside. 

For our purposes, we want to take advantage of businesses whose recent earnings have inspired an overreaction bias on the downside...BUT only if we see that the overreaction is based on misunderstanding the inherent qualities of the business. In other words, the recent earnings are a deviation from a longer-term trend of improved earnings in the future.