Part 1 of this article identified general biases in decision-making and Part 2 set forth biases that can affect investors’ perceptions of market and investment dynamics. This Part 3 of the article will discuss biases that can be found in the process of investment selection and valuation.
Investment Selection
● Market Point of View Bias. When some people review investment opportunities, they take a “top-down” or “bottom-up” approach to investment selection. Top-down approaches are based on the view that investment opportunities are primarily driven by country-level or macroeconomic conditions. Bottom-up approaches, on the other hand, are based on the perspective that investment opportunities are largely a function of specific company fundamentals.
Both of these approaches can be misleading as investment selection filters because most investment opportunities are affected by multiple levels of economic, financial and business performance factors.
More importantly, investment selection approaches that are anchored in different market points or that equate specific market points of view with investment strength or weakness can neglect to consider investment risks that are overshadowed by positive market performance or effective strategies for managing risks that are implemented by companies that operate in highly risky markets. Macroeconomic risks can become the basis for major competitive advantages.
● The Country Bias. Another very strong bias that some investors have when analyzing investment opportunities lies in how countries are perceived as gauges of specific investment opportunity strength. Some people may take the view, for example, that “China is a great place to invest” or “the United States does not represent value for money.”
In reality, the geographical boundaries of what is called a country often contain a very wide range of economic conditions. Highly developed countries may contain economically depressed areas and vice versa.
The same point applies to attempts to equate investment possibilities with descriptions of company direction such as the view that certain countries are “emerging.” The fact that certain economic indicators of a country are increasing, falling or moving sideways does not guarantee that these trends will continue and these trends moreover can have little correlation with the strength or weakness of many types of investment opportunities. Any country-level or macroeconomic trends can form the backdrop for a wide range of business models and paths to business success and failure.
● Investment Vehicle Bias. When considering investment opportunities, investors often invest through different types of investment vehicles and at times can make certain assumptions about where different investment vehicles lie on the risk/return curve. For example, an investor may take the view that investment vehicles with highly liquid portfolios are “less risky” and investment vehicles that do not invest in liquid investments are “more risky.”
Yet practically speaking there are not strict correlations between the nature of an investment vehicle and investment risk. While there are of course advantages in liquidity, liquidity that is based on holding publicly traded shares can expose investment portfolios to sharps drop in value if markets fall, even if market declines are completely unrelated to the fundamentals of the companies or instruments in the investment portfolio.
Similarly, a private equity fund which ostensibly lies at a riskier point of the risk/return curve may be in a better position to structure investment positions that provide a much higher return adjusted for risk even when the potential benefits and drawbacks of liquidity are considered.
● Selection Bias. Another strong bias in the process of investment selection is that investors typically make investment choices from a very small fraction of available investment opportunities. These biases can result from the limited nature of opportunities that are presented by one’s financial institution, preferences for investment opportunities that are geographically more accessible or even language barriers.
Another important form of selection bias is with respect to institutional operational and investment review and approval dynamics. For institutional investors, there is often a set of processes that are followed when considering investment opportunities and progressive levels of firm buy-in that can affect investment probabilities.
At early parts of the investment consideration cycle there may be a general bias against investment opportunities even if they are very strong. Conversely, once investments advance to a certain level of consideration, there may be a strong bias to approve them and “get the deal done” even if drawbacks have been discovered that would have removed an investment from consideration at a preliminary stage of investment review.
An additional bias that affects investment perception is the amount of available investment capital. Investors may take more aggressive investment positions when they are cash rich but become excessively conservative when they have little money. However, there is no correlation whatsoever between the ability of an investor to invest and the strength of an investment opportunity.
Yet another factor that creates a strong investment bias is time. For institutional investors that have to invest capital within a fixed investment period, there is pressure to become less conservative as the investment period draws to a close. Similarly, if investors have to exit an investment within a certain period of time there can be a greater tendency to view exit opportunities more favorably the closer to the required exit period even if there no change in investment risk.
Investment Valuation
Once investments have been identified they also must be valued to determine acceptable investment terms and conditions. Biases can also have a major impact on investment valuation.
● Overweighting of Time Components in Investment Cycle. When valuing companies some investors tend to place the most weight on a company’s present financial results while others heavily weight expected future performance.
In reality, it is important not to mechanically weight one part of a company or investment growth or performance cycle or another but rather carefully examine the company’s business model and overall commercial prospects and draw probable performance inferences from those prospects.
● Overweighting of Valuation Approach. Many investors have preferences regarding valuation approaches. Some investors may favor balance sheet approaches, others may use EBITDA multiples and others may use DCF valuation approaches.
The fact, however, is that each valuation approach has strengths and weaknesses: a balance sheet approach can be helpful when analyzing companies whose business is primarily dependent on fixed assets but less useful in analyzing companies whose value is not derived from fixed assets; EBITDA multiples can be useful for companies that have stabilized cash flows but not for companies who are expected to grow sharply; DCF approaches can provide insights into the impact of forecasted future performance on value but are highly susceptible to modelling error given the uncertainty of future free cash flows and risks.
● Overweighting Market Metrics. To value companies based on EBITDA multiples or the DCF method, it is generally necessary to extract multiples or discount factors from the market. The process of extracting this information is subject to bias, however, as metrics that are extracted from public markets may not be applicable to private markets or metrics that are good value guides in one country or region of a country may not be applicable in another.
● Overweighting Publicly Traded Stock Performance. It is common practice in valuation to discount the value of companies that are not publicly traded companies on the assumption that they are less professionally managed, have less diversified business models, operate with less regulatory oversight and have higher capital costs. In reality, however, private companies can have considerably stronger businesses than publicly traded companies.
Conclusion
This article analyzed biases that affect the process of investment selection and valuation. In Part 4 of this Article we will look at steps that can be taken to reduce biases in investment decision making.
The photo for this article was taken from Unsplash. The photographer is Joel Herzog.