Investors are prone to various types of cognitive bias that hamper their ability to objectively make rational decisions about their portfolios. A couple that are particularly insidious, and closely related, are endowment effect and loss aversion.
Endowment effect, sometimes called ownership bias, is the tendency for people to put a higher value on things they already own. It’s why retailers like to offer trial periods and money-back guarantees — they know that, once an item is in the hands of consumers, they tend to think it is worth more.
Loss aversion explains why many investors find it easier to pocket a profit than to dump a stock for a 20 percent loss. The losers keep holding, in hopes the stock will come back, while winners are nervous about letting a gain slip through their fingers. Yes, it can be harder to admit a mistake than to take a bow for a win.
One Contra Guy bought a bunch of speculative small-cap positions for his personal portfolio during the market mayhem last fall. All but one of these have subsequently been sold off for fat profits during this remarkable rally.
The lone exception is Material Sciences Corp., a manufacturer of specialized acoustical materials and coatings used to control noise and vibration. The stock was purchased last December at USD $1.21, and currently trades at 95 cents.
The company’s main customers are the automotive and housing industries, so top-line revenues have been dealt a potent one-two punch. Sales for the fiscal year ending February 28 were $187 million, down from $235 million the previous annum. Mind you, the long-term trend has also been one of contraction since 2000, when revenues exceeded the $500 million mark.
After trading in the $8-$18 range for a decade, the stock price rapidly fell apart during the October-November massacre, which crushed so many small-cap stocks to ridiculous prices.
Material Sciences was purchased because it was essentially trading at a level that suggested investors thought bankruptcy was imminent, yet the balance sheet indicated otherwise. Despite disappointing sales, the company had carefully managed cash flow and remained debt free.
Aside from a brief foray to the $1.50 mark in early May, the shares have drifted lower, while the company’s peers have been on a tear. Wouldn’t that be a good reason to overcome any loss aversion and dump the laggard?
The issue isn’t really the modest paper loss — it is a sunk cost which is now basically irrelevant– but whether the market’s cold shoulder makes sense or not. To answer that question requires a closer look at how the company is operating.
Management has been able to rapidly downsize operations in lockstep with its declining prospects. Despite a horrible year, the cash balance actually improved by $2.8 million to $10.7 million. It sure looks like management, to a large extent, anticipated this recession, rather than being caught flat-footed.
The bankruptcies of Chrysler and General Motors have undoubtedly tightened the screws on automotive suppliers. Another hurdle to recovery for Material Sciences is the loss of its NYSE listing. The pool of potential investors, especially institutional ones, is much smaller in the over-the-counter market. The bid/ask spread is just plain nasty.
But for this contrarian, all of these reasons suggest an atmosphere of maximum pessimism, rather than a reason to sell. The company still looks more like a plucky survivor than an enterprise in collapse. Is this an accurate assessment, or is the endowment effect at work? That’s the thing about cognitive bias: even when you are aware of the problem, it’s impossible to know how much it is affecting your decisions.