Investors expect active money managers to outperform benchmark indexes. Many strategies can succeed in the long term, but it can be difficult for the average investor to wait patiently.
Raife Giovinazzo, the manager of the Fuller & Thaler Behavioral Small-Cap Equity Fund FTHFX, -0.40% described how he has made use of the research and theories of behavioral economist Richard Thaler to gain an edge on stock selection and timing by taking advantage of “mistakes” by investors, money managers and analysts.
Thaler, a professor at the University of Chicago Booth School of Business, was awarded the Nobel Memorial Prize in Economic Sciences in 2017 for his work in behavioral economics. Thaler has described that branch as “economics about humans” who don’t fit neatly into the behavior patterns assumed in traditional economic theory. Giovinazzo said his investment decisions revolve around “how people behave, as opposed to how they should behave.”
Read: Nobel winner Richard Thaler on why we’re idiots about money and what we can do about it
Fuller & Thaler Asset Management was founded in 1993 by Thaler and Russell Fuller. Daniel Kahneman, professor emeritus of psychology and public affairs at the Woodrow Wilson School at Princeton University, serves as an adviser to the firm. Kahneman was awarded the 2002 Nobel Memorial Prize in Economic Sciences for his work on psychological and experimental economics.
Kahneman was Giovinazzo’s undergraduate adviser at Princeton, and Thaler was his doctoral adviser at the University of Chicago Booth School of Business.
Fuller & Thaler Asset Management is based in San Mateo, Calif., and has $9.6 billion in assets under management in private accounts and mutual funds.
In an interview, Giovinazzo said: “Everything we do is based on behavioral finance — the study of investor mistakes.” Those mistakes can be summarized as overreactions and underreactions. “We try to buy when we think people are likely to overreact to bad news or underreact to good news.”
So Giovinazzo’s strategy combines value opportunities from overreactions to bad news with growth opportunities from underreactions to good news.
“People tend to overreact to a first impression and then they underreact to further impressions,” Giovinazzo said. If a company has turned a corner and become significantly more profitable, for example, analysts’ natural human behavioral biases may lead them to increase earnings estimates more slowly than they should.
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The Fuller & Thaler Behavioral Small-Cap Equity Fund tends to hold some cash to take advantage of buying opportunities, Giovinazzo said. “We were actually in the high single digits at the end of third quarter. When the prices dropped [the Russell 2000 Index was down 20% in the fourth quarter], we saw a lot of insider buying. We deployed cash and made a lot of purchases and went to a very low volume of cash.”
Value example
A company may be going through a difficult period, with selling pressure pushing its share price so low that insiders (senior managers of the company) begin buying shares. That’s when Giovinazzo will begin buying, assuming he is comfortable with his team’s fundamental analysis of the company.
“Our investment process looks for insider buying as the event that suggests that maybe the rest of the market is overreacting to these struggles,” he said. So the insider buying is a catalyst to further research that may lead to a buying decision.
Giovinazzo cited Bob Evans as an example. “Between mid-2105 and mid-2016, the company bought back roughly 10% of their shares,” Giovinazzo said. The shares had been going through a long decline because “a lot of people had questions about the restaurant business,” he said.
But many investors may not have realized that Bob Evans also had a business selling frozen products in supermarkets, which Giovinazzo said was “doing terrifically well.”
“So we saw the insider buying, we saw the buybacks. We thought people were overreacting to the restaurant business and underreacting to the refrigerated business,” he said.
So the Fuller & Thaler Behavioral Small-Cap Equity Fund bought shares of Bob Evans in mid-2016 (when they were trading below $40). Bob Evans sold its restaurants to Golden Gate Capital in January 2017 and the rest of the company to Post Holdings POST, -0.04% in September 2017 for $77 a share in cash.
Growth example
“In general, people underreact in two circumstances — they underreact to dull information and they underreact when they have very strong prior expectations,” Giovinazzo said.
“Dr. Kahneman found that when people make numerical forecasts, they engage in ‘anchoring’ — they adjust away from an anchor, but they do not adjust enough,” he added. This is the normal thought process that leads sell-side analysts to be cautious when raising earnings estimates and share-price targets for companies when earnings are improving rapidly.
So when he sees very good news, Giovinazzo may be looking at a signal that people will underreact, presenting a buying opportunity for the fund.
One example is Landstar System LSTR, -0.87% which Giovinazzo described as “sort of the Uber of trucking.”
“Their value add is through their routing system, to connect the business owners that actually own the trucks,” he said.
The fund purchased shares of Landstar in October 2016 (when they traded below $72), following a positive earnings surprise, and after the company had been buying back shares. The shares closed at $110.08 on Feb. 22.
“Asset-light companies are more likely to have positive earnings surprises, because they are much easier to grow. Landstar, by focusing on the routing, as opposed to owning the trucks themselves, was able to grow much more quickly,” Giovinazzo said.
Share classes and performance
The Fuller & Thaler Behavioral Small-Cap Equity Fund was established in September 2011 and has about $1.2 billion in assets. Its two main share classes — investor shares FTHNX, -0.41% and institutional shares FTHSX, -0.40% — both have five-star ratings from Morningstar.
The investor shares have a $1,000 initial minimum and annual expenses of 1.14%, which Morningstar considers “average” for its “small blend” fund category. The institutional shares have an expense ratio of 0.85%, which Morningstar considers “below average,” and a minimum of $100,000 if you invest directly with Fuller & Thaler. If you work with an investment adviser, your minimum for the institutional shares might be lower, depending on the relationship between your adviser and Fuller & Thaler.
Here’s how both of the fund’s share classes have performed against their benchmark, the Russell 2000 Index, and their morningstar category, through Feb. 22:
| Total return - 2019 | Total return - 2018 | Average annual return - 3 years | Average annual return - 5 years | |
| Fuller & Thaler Behavioral Small-Cap Equity Fund - investor | 15.6% | -13.4% | 17.8% | 10.3% |
| Fuller & Thaler Behavioral Small-Cap Equity Fund - institutional | 15.7% | -13.2% | 18.0% | 10.4% |
| Russell 2000 Index | 18.1% | -11.0% | 17.5% | 7.9% |
| Morningstar Small Blend category | 17.2% | -12.7% | 14.6% | 6.8% |
| Source: Morningstar Direct, FactSet | ||||
Top holdings
Here are the Fuller & Thaler Behavioral Small-Cap Equity Fund’s 10 largest holdings (of 89) as of Dec. 31:
| Company | Ticker | Share of portfolio | Total return - 2019 through Feb. 22 | Total return - 2018 | Total return - 3 years |
| Landstar System Inc. | LSTR, -0.87% | 4.1% | 15% | -6% | 89% |
| Murphy USA Inc. | MUSA, +0.12% | 4.1% | 4% | -5% | 25% |
| Medpace Holdings Inc. | MEDP, -21.51% | 4.0% | 32% | 46% | N/A |
| Bruker Corp. | BRKR, -1.66% | 3.9% | 27% | -13% | 50% |
| Jabil Inc. | JBL, -0.10% | 3.5% | 18% | -4% | 45% |
| Blucora Inc. | BCOR, -0.42% | 3.4% | 1% | 21% | 328% |
| First Citizens BancShares Inc. Class A | FCNCA, -0.72% | 3.0% | 17% | -6% | 87% |
| Comfort Systems USA Inc. | FIX, -0.24% | 2.9% | 25% | 1% | 106% |
| Fulton Financial Corp. | FULT, -0.26% | 2.7% | 11% | -11% | 45% |
| Hancock Whitney Corp. | HWC, -0.96% | 2.6% | 26% | -28% | 96% |
| Sources: Morningstar Direct, FactSet | |||||
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