Avoid anchoring effect for optimal stock selection

Let us imagine two different scenarios playing out in a room filled with around 100 people.

Scenario A
You make a statement that the length of the Nile is 6,650 km and then ask the question, “What is the length of the river Ganga?”

Scenario B
You make a statement that the length of the Narmada is 1,289 km and then ask the question, “What is the length of the river Ganga?”

It may surprise readers to know that in Scenario A, the average figure of the guesses made by the 100 people in the room would be significantly higher than that of the average of the guesses made in Scenario B.

The correct answer in this case is 2,620 km according to Wikipedia, but that is not the point.

Readers may wonder how people could guess so differently in the two scenarios. After all, most people would know that Nile is the longest river on earth and that the Narmada is much smaller than the Ganga and that the length of one river has no connection with the length of any other river.

Bargain hunting
The answer to this question lies in a tendency called the anchoring effect. Anchoring means that the mind latches on to any given number – relevant or irrelevant – and holds on to it.

Instead of the length of the Nile and Narmada, we could well have used two phone numbers or PIN codes and the effect would have been the same!

Street vendors, home-makers and kids understand this aspect quite well. If the street vendor quotes a very high price in the beginning, the chances are high that the final negotiated price may also be high. Home-makers also understand this and negotiate accordingly. Kids tend to make unreasonable demands and later settle for ‘reasonable’ concessions, which otherwise would seem completely unreasonable. Real estate agents and jewellery salespersons tend to show outrageously expensive stuff deliberately, so that they later seem very reasonably priced in comparison.

Anchoring and investment decisions
The anchoring effect has very important implications for finance and investments. For example, the 52-week high/low prices or the all-time high /low prices of stocks create important anchoring biases. A stock that has fallen 40 percent from its peak seems cheap. A stock that has doubled in value from its 52-week low price seems expensive. A P/E (price-to-earnings) ratio of 40 seems cheap, when in the recent past the same company may have traded at a P/E ratio of 80.

Investors should keep in mind that, in 2017, there was a very strong increase in valuations that was being paid for small and mid-caps, NBFCs (non-banking finance companies) and consumption-related stocks.
It does not pay to be anchored to those high prices or multiples.

The biggest gains in equity investing come about when earnings growth as well as re-rating of valuation multiples happen in tandem. The biggest losses come from a fall or disappointment in earnings combined with a valuation de-rating.

Biased growth estimatesAnchoring can happen on two fronts. It can happen in estimating a sustainable growth rate for a business as well as reasonable valuation multiples. It pays to remember than when developing countries have GDP growth rates of four-to-eight percent and the developed world has growth rates of 0-4%, no company can grow at a pace of 30-40 percent perpetually. There may be a short span of time for which companies can sustain high growth rates. Ultimately, countervailing forces such as the base effect, competition and anti-trust regulations kick in.

Recently we have noticed that some fancied consumption stocks reported somewhat disappointing earnings. This underwhelming show has caused the stocks to correct quite a bit and prices are now significantly lower compared to their all-time highs. A stock falling 30-40 percent is no reason to buy it. You need to study and understand the long-term growth rates and valuation multiples. The multiples enjoyed by companies during the last three-to-four years may not be representative of the fair multiples for stocks that fall under any of the three themes of small and mid-caps, NBFCs and consumption.

It has been famously said, “A stock that falls 90 percent from peak is a stock, which first fell by 80 percent and then further fell by half!”