For the last 40 years, Warren Buffett has famously been releasing his letters to shareholders. Every year retail investors, money managers and the media clamour to find out what kind of outlook he has for the upcoming year. Over the decades Buffett has touched on politics, the economy, the housing crisis, Presidential campaigns and of course the stock market.
For the most part, Buffett is an optimist. Much of his fortune in recent years is centred around buying undervalued companies and holding them for long periods of time. He’s the most famous value investor along with his mentor Benjamin Graham. Overall he is certainly an optimist when it comes to being long stocks.
However, in the long-term, can we actually gain a market edge from by into what top money managers like Buffett and others have to say?
Interestingly, a new paper that has been released suggests that we can – but there’s a catch.
As it turns out, it’s not the optimistic managers that we should be paying attention to. It’s those with the most pessimistic outlooks that should be of most value to potential investors.
The study looks closely at the language that some of the top US fund managers use when they write their quarterly updates to shareholders. The language in the letters can be measured by looking at the number of negative or positive words. Interestingly there’s a strong relationship between how the overall stock market is doing and the tone in which managers are writing their updates to shareholders.
Not surprisingly, when times are good, overall the number of positive words is high. When times are tough, the number of negative words dramatically increases. However to gain a market edge we need to take this one step further.
While on the surface the way in which managers are writing does give us an indication of where the market sits, it’s those with the most pessimistic tone that we should be paying attention to.
The study looks at US-based funds between 2003 and 2013. They found that it was the managers that used significantly more pessimistic words in their shareholder letters, were able to outperform the market in the subsequent periods.
If the level of negative tone in the letter increased significantly (by one standard deviation), that led to an increased return of 3.5-5% per year.
In contrast, the shareholder letters that were bullish and positive didn’t earn a return better than what the market was offering.
So this raises the question, why?
Psychology of Performance
It’s been suggested that the reason for the improved level of outperformance is due to the effort in which a money manager puts in. When they have a period of outperformance and earn strong returns, from a psychological standpoint, they aren’t incentivised to work as hard as they possibly could.
On the other hand, a manager who has performed poorly in a given quarter, is more likely to allocate more time and resources and work harder to achieve an improved level of performance.
The level of outperformance was also strong after a recent period of volatility. Generally speaking, volatility rises when markets fall. If markets have been dropping and shareholder returns are poor, that’s also going to contribute to an overall negative tone in a shareholder letter.
Another idea is that stock market returns are largely mean reverting. When there are periods, whether that’s days or weeks, where stock markets decline. Invariably, they bounce back to where they came from, quickly and sharply.
Often downside moves are exaggerated and this can play into the tone in which a manager will use when they are reporting on their performance and the immediate outlook.
Implications for Investors
This study is an interesting one from a psychological and contrarian point-of-view. Just as Warren Buffett suggests investors need to be looking for opportunity when people are scared, so too it seems when looking at money managers.
If returns are mean reverting then a period of underperformance can be a good time to buy into a fund.
In Australia the number of managed funds, LICs and ETFs continue to grow. For actively managed funds, taking the time to look through shareholder updates has the potential to offer some key insights.
Listed Investment Companies (LICs)
In Australia, there is an increasing number of Listed Investment Companies (LICs) that allow investors easy access to funds directly through their broker. There funds all report regularly to the ASX and investors are able to easily access company reports which outline their recent performance and what the immediate future looks to hold.
ETFs
While many ETFs are passively managed in that they simply track an index, the world of exchange-traded funds continues to grow and that includes those that are actively managed. Again this offers an opportunity for investors.
Managed Funds
Managed funds make up a large portion of many investors superannuation and investments. By examining both the short run performance and the tone of the messaging coming from the manager, investors have the potential to both improve their performance and find better opportunities to add additional capital.
Half-Full or Half Empty?
Overall though, it’s fair to say that fund managers as a whole are far more pessimistic than most retail investors. Most like to find a reason not to buy a stock, rather than why they should buy one. Generally, they are in the glass half empty camp.
It’s clear though, that the tone of a manager uses in his or hers messaging to shareholders, has a lot to do with their recent performance. If you’re looking to gain an edge in the short term then it is clearly worth considering how negative or positive they appear to be and don’t be afraid to look for opportunities when markets are either down, or when a particular fund manager has had a short-term period of underperformance.