Q&A: ROBERT VISHNY "IT’S HOW HUMAN NATURE AFFECTS THE BEHAVIOR OF STOCK PRICES"

One axiom about academics is that classroom theories often lose their luster outside ivy-covered walls.

That doesn’t apply to University of Chicago Professor Robert Vishny or his partners, University of Illinois Professor Josef Lakonishok and Harvard University Professor Andrei Shleifer.

After studying the psychology of investing for nearly a decade, the three behavioral finance teachers hung out their shingle in 1994 to moonlight as money managers at Chicago-based LSV Asset Management.

They are considered heretics by efficient-market theorists, who insist it’s impossible to beat the market consistently and who recommend investing in passively managed index funds.

Yet the three have outpaced the market using a computer model that applies their research on how people’s judgments lead to predictable stock price patterns. And a number of other academics and money managers have embraced the behavioral investing philosophy. Since the firm’s inception in December 1993, LSV has earned an average annual 27.9% return, outperforming the Standard & Poor’s 500 stock index by more than 2.5 percentage points each year after fees.

The firm has attracted $2.9 billion in assets, mostly from corporate pension plans and university endowment funds. Mr. Vishny says the firm isn’t advising any publicly available mutual funds yet, but is exploring the option and expects to make a decision this summer.

Q What is behavioral finance?

A It’s how human nature affects the behavior of stock prices. For example, people seem to consistently overestimate the value of past growth rates in predicting future growth rates. So companies that have grown rapidly over a 10-year period will be given very high price-earning ratios and the expectation that growth will continue. But actually, growth is very hard to predict based on the past.

People also place too much comfort in investing in companies that are well run and highly profitable, and don’t pay enough attention to companies that are in need of improvement, but at the current market prices are bargains. Even if money managers are aware of some of these anomalies, they tend to be timid in taking positions to exploit them because they’re exposed to holding names that could end up real losers.

Q Your philosophy seems to marry two disparate approaches, value and momentum investing.

A The usual momentum investor is a growth investor who’s buying at very lofty multiples and is using momentum to chase a trend while it’s going up, and get out before it falls off the cliff. Momentum also works in the value universe. The idea is that a company becomes a value stock over a long period of time — five or seven years — of being beaten down and having poor growth. The market slowly changes its mind and the momentum measures we use are designed to capture when the market is starting to change its mind over a three-to-12-month period.

Q What indicators measure the market’s attitude toward a stock?

A We look at price movements –when analysts are becoming more positive on a stock and earnings are turning positive relative to what was expected. And we’re looking for stocks that are cheap on a multiple of cash flow, earnings or book value. Our ideal stock has all of these.

Q Based on your parameters, is there always a portion of publicly listed companies that look to be comers again?

A There are always stocks that fit the pattern across a range of industries. Since we don’t kick the tires on the companies we’re buying based on the numbers, no stock gets more than a 1.6% initial weighting in our large-cap portfolio. So we’re able to keep down our exposure to individual industries and stocks and have a lower risk profile as a result.

Q Where has that led you lately?

A Sleepy value stocks have disproportionately been in the financial and utilities sectors, but the lists do change. Allstate Corp. has remained attractive for some time. Right now we also like Boston Edison Co., an electric utility with about a $2 billion market capitalization. We also like Bethlehem Steel Corp., Darden Restaurants and Navistar International Transportation Corp. In all of these cases, the stocks are very cheap relative to their fundamentals, have done poorly over the last few years, but have done extremely well recently.

Q Hasn’t Allstate enjoyed a fairly strong run since it broke away from Sears?

A That’s what we’re looking for. We’re not trying to buy value stocks at the bottom. We’re trying to buy things that are fairly cheap on fundamentals and are showing signs that the market is waking up to them.

Q Any other sectors look attractive?

A The airlines as a group are coming up on our list. This includes AMR Corp., the parent of American Airlines, which has a $13 billion market capitalization. We also like America West Airlines and Continental Airlines.

Vite

Robert Vishny, 39, University of Chicago

professor and principal, LSV Asset Management, Chicago. Assets under management, $2.9 billion

LSV large-cap portfolio composite returns: Year to date, 13.8%; since inception, Dec. 1, 1993, 27.9% (annualized, before fees of 0.30%-0.60%)

Standard & Poor’s 500 stock index: Year to date: 15.1%. Since Dec. 1, 1993: 24.8% (annualized)

Returns through April 30

Source: LSV Asset Management