- Fred Stanske runs three behaviorally driven funds for Fuller & Thaler Asset Management.
- The firm, co-founded by Richard Thaler, capitalizes on investor biases to find missed opportunities.
- Stanske shares two mispriced, under-the-radar stocks amid rising irrational behavior in the market.
- Visit the Business section of Insider for more stories.
With the ever-increasing bitcoin craze, SPAC boom, and retail trading fervor, Fred Stanske is seeing a lot of irrational investor behavior.
But that’s not necessarily bad for Stanske, who manages the $4.3 billion small-cap equity fund, $96 million small-cap growth fund, and $12.7 million micro-cap equity fund for Fuller & Thaler Asset Management, the behavioral investing firm co-founded by Nobel prize winner Richard Thaler.
Established in 1993, the firm is a pioneer in applying behavioral finance — the study of investor psychology and its influence on decision-making in financial and capital markets — to fund management.
“We believe that most investors don’t always act rationally even though the market assumes everyone’s rational,” Stanske said in an interview. “In behavioral finance, we think we all have biases and assumptions, which can create opportunities, and we try to exploit those opportunities.”
In the case of the small-cap growth fund, Stanske tries to capitalize on the specific kind of behavioral biases that may cause the market to underreact to new, positive information such as earnings surprises. The fund gained 50.87% last year and has returned 12.53% this year, according to Morningstar data.
Another outperformer is his micro-cap fund, which has returned 32.02% year-to-date and beaten 99% of its 687 category peers. However, his small-cap equity fund has trailed its index, returning 10.05% last year and 12.81% year-to-date, Morning data shows.
How to identify investor misbehavior at the stock level
While some investors are always behaving irrationally, exploiting the opportunities derived from their misbehavior requires skill, patience, and discipline.
For example, during the GameStop trading frenzy, Stanske saw “one of the attention-grabbing stocks” (not GameStop) in his portfolios double in value in one day.
“Given there was no new information on the company we took profits and reduced the position back to its original size in the portfolio,” he said. “Other than that isolated incident we have not wavered from our long-term behavioral investing process.”
The process starts off with screening for situations where he believes the market has underreacted to positive changes or news at a company.
From there, Stanske and his team conduct fundamental analyses to determine whether that new event has led to a sustainable change in the earnings of the company. If that is the case, then he will buy the stock.
The process may sound simple enough, but the execution is nothing near easy as investors, including himself, tend to make the mistakes of “anchoring” and fall into the traps of the “disposition effect.”
Stanske explains that anchoring refers to how humans tend to remain attached or “anchored” to their prior views or expectations when presented with new information.
“When analysts are building these large models for these companies that have 500 variable spreadsheets and suddenly they are presented with new information that is different than their expectations, they’ll go back to their model and adjust that model,” he said. “But they’re usually not going to adjust it enough if this information is new, positive, and permanent because they’re anchored to that old model.”
The disposition effect is seen in investors’ willingness to take profits off of their winning stocks and their aversion to exiting the losers in their portfolios.
“It leads to lots of activities when there are new information and positive price reaction, people who own the stock will likely sell in that situation,” he said, “and that usually gives us an opportunity to take advantage of that.”
On top of that, Stanske and his team also need to navigate the often-overlooked overconfidence syndrome.
“We’re all very overconfident as human beings, we have to be to survive, so when we’re presented with information that’s different than our expectations, we used to go back to our prior expectations, ” he said. “Sometimes, because we’re overconfident in those expectations, it can lead to bad decisions in terms of looking at a company or making decisions in life in general.”
Two mispriced, under-the-radar stocks
Unlike most investors, Stanske does not seek to keep high-conviction names in his portfolios because they can lead to “biased forecasting and poor decision making.”
Instead, his behavior-driven approach has steered him to special situations where investors are underreacting to positive new information. He shares two stock picks whose potential he believes has yet to be properly evaluated by Wall Street.
One example is jeanswear company Kontoor Brands (KTB), which has jumped 20% year-to-date after reporting solid fourth-quarter revenues and adjusted EBITDA.
“Kontoor has beat analysts’ earnings estimates in the last three quarters,” he said. “They’re the manufacturer of Lee’s and Wrangler’s Jeans and other apparel products, and have done well with cost controls, digital initiatives, and reaching new markets and customers.”
Another example is dental equipment and services company Envista Holdings (NVST), which has gone up 17.8% this year after reporting strong fourth-quarter results.
“Envista Holdings is another name where we believe investors were underreacting and has also beat expectations the last three quarters,” he said. “[Their] new products and cost savings initiatives have led to better margins and earnings in the last year.”
Know what you own
Given the pockets of froth in today’s market, Stanske believes that it’s critical for investors to know and understand what they own.
Despite the increasing “hype” around passive investing in the past few years, he has seen the number of unprofitable companies in his benchmark index — the Russell 2000 Growth index — grow from approximately 25% of the index ten years ago to over 50% of the index today.
“If you combine that with some of the irrational Gamestop or meme stock activity, the small-cap indices are filled with ticking time bombs,” he said. “Gamestop was an example of a stock that was owned by the passive small-cap index investors but few active managers. It became like a game of hot potato as investors passed it around the circle hoping they weren’t the ones holding it when the music stopped.”
“A lot of people got burned. More are likely to get burned,” he added.
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