James Montier: You Can Turn Behavioral Biases Into An Advantage Using A Valuation-Based Framework

Johnny HopkinsJames Montier4 Comments

We’ve just been listening to a great interview with James Montier on Meb Faber’s podcast. During the interview Montier provides some great insights to help investors protect themselves from their behavioral biases. Montier says that you can actually turn behavioral biases, like anchoring, into an advantage using a valuation-based framework. Here’s an excerpt from that interview:

Having the advantage of a valuation-based framework is effectively turning a behavioural bias which is anchoring, hanging on to kind of sometimes irrelevant information as the basis of decision-making and actually turn it to your advantage.

So, a good example of anchoring with some German judges, and they were asked to sentence people to jail. But before they did so they had to roll some dice. And the dice were rolled and they were rigged. So they either gave the answer of three or nine depending on which set of dice are being used. And what was interesting was the judges’ sentences were directly proportional to whether they happen to roll a three or whether they happen to roll a nine irrespective of the situation of the crime. So, the judges, without knowing it, are actually anchoring to this irrelevant piece of information.

So rather than anchoring to news stories or value at risk models, think about anchoring to valuation, because then, let’s say, the world falls apart like it did in 2008, 2009, early 2009, you’re sitting there, you’re looking at valuations, you are going, “Wow, this is a tremendous opportunity. I can buy assets that are 10, 11, 12 real.”

Conversely, in 2007, you’re sitting there going, “I don’t want to own assets because these things are hideously expensive. Why would I wanna go and buy some? So, it doesn’t make any sense to go and buy in that kind of environment. I’m gonna keep my powder dry and go and invest when the opportunity set is better.”

So, that valuation framework helps you have an anchor that is actually sensible rather than clinging on to something that is essentially random noise like the newspaper headlines. So, I think you can do that in lots of different ways. You could do it with stock valuations as well. So, rather than building a dividend discount model or discount cash flow model where we know…

I used to work, you know, with analysts for a very long time, and I knew the way they built their models. They’d look at the share price and they go, “Oh, I want to be a buyer. I need to have a share price target that’s 10% higher, therefore I’m just gonna notch my growth up until I get my DCF to be 10% higher than current price.

So, you know that they’re not using a DCF in a sensible fashion. Rather than falling into that trap, reverse engineer the problem. So, say, “Okay. What do I need to believe to justify today’s valuation in terms of growth?” And then have a conversation around whether that growth is actually deliverable or not.

And one of the things I do is I plot a histogram, if you like, of all the companies in history that I get my hands on and show where their growth rates are, and then I can say, okay, well, let’s say I pick a stock and it’s in the 99th percentile, “Why do I think this stock is gonna be in that 99th percentile?” Whereas if it’s down in the 5th percentile, I’m like, “Well, pretty much everybody hates this stock. It’s really beat up. What could go wrong? And let’s have a conversation about the risks.”

But in general, I should be pretty much predisposed to that because expectations are very low. So, it’s a good way of kind of flipping the problem of anchoring to the share price on its head. So, these are all kind of good elements of process that can try and make you behaviourally robust. We talked about triangulations, looking for different signals and seeing if they all agree, you know, that makes you more confident. That’s good. Right? If they’re all different, you gotta be a little more circumspect about your outlook. So, I think process is vitally important because it’s the one thing an investor can control and really help them admit that that their own worst enemy is likely to be themselves.

You can listen to the entire podcast here:

You can read the entire transcript of the interview at Meb Faber’s website here.

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4 Comments on “James Montier: You Can Turn Behavioral Biases Into An Advantage Using A Valuation-Based Framework”

  1. Interesting interview.

    I also think that having a solid process (one that helps falling victim to our behavioral biases) is the key to success in investing.

    2nd key takeaway: Understanding growth is key. I like the idea of plotting a histogram to assess current growth rate / expectations versus history/other companies.


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