The Herd Mentality

Neil Cataldi Blog, Educational 2 Comments

There is a pervasive herd mentality on Wall Street today. This is not a new phenomenon; however it is becoming even more evident due to the advent of new mediums. Financial advisors lack alignment and creativity, and are stymied by arbitrary guidelines, in order to fit within their scalable business models of efficiently servicing large amounts of clients. Furthermore, with the advent of Twitter and Seeking Alpha, and the like, companies can be easily bullied by hucksters and pumpers, who can drive millions of shares in trading volume. Is this a new paradigm for how research and investment advice is disseminated or is it simply a new mechanism for creating hype and attention to companies that are underfollowed? The case for both arguments is strong, and these new outlets (web and social media) are further fueling a herd mentality where almost any unregulated individual can build a brand to steer followers in one direction or another, not unlike the herding of sheep.

As a basis for this discussion, it is important to first consider how the average investor accesses the financial markets, which is through a traditional financial advisor. This model is long-standing, and has structural defects that contribute to investor herding, on a massive scale. When a financial advisor chooses individual equities or mutual funds on your behalf, you’re likely at a disadvantage. Why? The advisor is not, in any way, incentivized to make you money other than collecting a commission or an annual wrap fee. They are likely deploying these investment choices across hundreds of clients, therefore constraining each of their clients to arbitrary common denominators. Sounds like herding to me. Furthermore, when you lose, they still win, as their downside is only realized when you fire them, which is rare. The average investor portfolio is highly predictable, lacks originality and lacks true diversification. When it comes to compelling, smaller company growth stories, investors invariably lack exposure, often because their financial advisor doesn’t have the time, skill or motivation to uncover them. They stick with the larger “safer” names, selected from a very small pool of hundreds of choices. What do they really know about these companies? Did they talk to the CEO to get a stronger understanding of the company and its growth prospects? Most of the larger brokerage firms even prevent client ownership of smaller companies, for arbitrary reasons that are designed to limit their liability, at the firm level. There are literally thousands of smaller companies out there! This traditional approach forgoes exceptional market opportunities that drive meaningful returns and diversification. Try buying a smaller company via your broker, and you will be dissuaded or shut down, in almost every circumstance. Financial advisors love to herd sheep into their corrals and push each one through their systematic process.

As far as the new media changing the landscape, Seeking Alpha contributors are paid and typically already have established their position, in advance of publishing, long before you do. Where is the alignment there? Just read the disclosure at the bottom of the page. And with Twitter, the ‘tweeter’ may be exiting their position as you, and others enter, en masse. Again, no alignment. We see this game quite often, which is akin to musical chairs – the last person standing always loses. There’s a reason more and more people are touting their subscription services and stock picks on Twitter. Anyone can do it, and it is an unregulated regime, and the research quality is often very low. Are they talking to management teams? Are they doing channel checks and talking to suppliers or customers? Or are they just finding buzzy stories with low float share structures that will move more than the average stock when they’re finished pumping it? The obvious need not be stated.

As a portfolio manager of a microcap strategy, I am the target of endless investor relation (IR) calls as well as companies that would like to introduce themselves and pitch their story. In recent years, I’ve noticed that both parties typically ignore the impact these new mediums can have on their valuation. Companies struggle in knowing where their trading volume is coming from and their IR reps are often equally puzzled. I would term this volume as “fast money,” which can either be a detriment to investing, or create advantageous liquidity, depending on your perspective or positioning.

Enter the psychology of investing. It has always fascinated me. My career has spanned positions in trading, research/analysis, and the management of capital portfolios across numerous asset classes. While some asset classes are more efficient than others, the opportunities are always there. One just has to take the time, roll up your sleeves, and find them. As a contrarian investor first, I believe firmly that the best opportunities are found either 1) when the world hates the investment in question or 2) when the investment in question has yet to be found by the masses. Negative sentiment is easy to identify with the first point as declines in valuation, insider selling, unfavorable news, etc are all components we come across frequently. Capitulation is a bit more of an art than a science but one that can be even more fruitful, especially in the small and microcap universe. However, finding the company before the masses is the true challenge.

I’m often asked how I source ideas and the common belief is that fundamental screens yield the best opportunities. While that may be true for many, my approach is different and I aim to beat the screens. Therein lies the point, if the consensus within the population is doing one thing, you want to do something else. Discovering companies before they tout their inflection points on a conference call or in a press release is not as hard as it may seem. It takes a good deal of time preparing to speak with management and connecting the dots with supplemental research. When you can succeed at this, you will succeed in the microcap space. And when you find that opportunity, the herd will come to you long after you’ve already established your position.

I began my career trading options on the Philadelphia Stock Exchange. A mentor once said, the real money in options is made trading volatility, not the day to day move in price. The theory is that volatility increases or decreases are worth much more than daily fluctuations in the price of an underlying stock. I never forgot this principle and the same can be applied to investing in microcap stocks. Those who find the companies early stand to benefit much greater than those who follow the herd to capture a smaller, faster move.

In sum, investors need to be extra mindful of the legacy and newer, continuously evolving dynamics that are driving the financial markets today, often by improperly aligned actors.

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Comments 2

  1. Great post Neil. It seems like momentum buyers are everywhere these days. Some of the “pumpers” on Twitter and the like are detrimental to the evolving, and often times emerging, stories that some great microcap names have. It’s a shame but it’s just another dynamic to deal with and possibly a good liquidity event as you pointed out.

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