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Michael L. Boyer's  Instablog

Michael L. Boyer
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Associate Professor, University of Alaska, Southeast. B.L.A. University of Alaska, Southeast MS Mgt Texas A&M, Commerce J.D. University of Oregon
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  • Profit From Predictably Irrational Companies

    Investing Time in Reading

    In The Warren Buffett Way, Robert Hagstrom notes Buffett's voracious reading and notes that long time Geico investment manager Louis Simpson (now retired from Geico but with a record heralded by Buffett in this Bloomberg piece) believed the "most important job of an investment manager is to keep reading and reading until an idea materializes" (123).

    Some of the richest reading for investing ideas may be behavioral economics and psychology. Investors need not peruse jargon laden, technical articles in obscure journals to get started. Professor Dan Ariely's book on this topic, Predictably Irrational: The Hidden Forces That Shape Our Decisions, was a readable best seller (the pages cited are to the 2009 revised, expanded version).

    The book provides insights into an array of topics: social policy, public health, education, etc.; however, many topics can be applied directly to business and, in particular, investing. Through careful reading, investors may find concepts and strategies companies can use to profit from some irrational (but predictable) behaviors of consumers.

    Predicting the Irrational?

    A dual PhD (cognitive psychology and business administration), Dr. Ariely is a creative researcher with a practical bent. Much of his work points to a "coherent arbitrariness" in our choices. Simply put, people may not always make completely rational choices (in their purchases, tastes, and even dating), but the irrationality is also often predictable, as his data from simple experiments reveals.

    Questioning the conventional wisdom with empirical research is a personal affair for Ariely. As an 18 year old Israeli, an explosion left him with 70% of his body burned and covered in bandages for 3 years.(xii-xiii). His experience in the way bandages were removed to minimize pain gave him a tremendous insight into the "conventional wisdom" versus the results of empirical studies and what was really going on in the mind and experience of the patient (XIV).

    Ariely began his academic career in Israel and in the United States asking questions that challenged basic assumptions. For example, he thoroughly questions the underlying assumption that consumers in marketplace are always "rational" in their choices, an assumption often relied on in fields like economics.

    Through his simple but well designed experiments--think selling chocolates at various prices on a table-- Ariely offers numerous core ideas investors might use and apply. His books and research are compiled on his website. Such studies might be used by investors, in tandem with studying conventional investment information, and many possible applications emerge.

    Applying The Predictably Irrational

    Ambiance and A Cup of Joe

    Ariely's experiment with coffee satisfaction should have anyone who has read about the history of Starbucks (SBUX) on the edge of their seat. Ariely's predictably irrational experiment may hint at the root of Starbucks' and other firm's success.

    Would you pay more or like coffee more served with a silver spoon or a broken white Styrofoam cup? Ariely found people gave the same coffee higher ratings and expressed a willingness to pay more for it when he added silver spoons and high end condiment containers versus white Styrofoam cups with handwritten red letters on them (204). The same coffee but with slightly changed ambiance made all the difference. Irrational perhaps--but predictably so.

    Starbucks' meticulous attention to the surfaces, sounds, smells, and high-end finishes are a tangible expression of this finding about the coffee experience and consumer preference. However, most investors know Starbucks has taken this ambiance premium global already and it may be priced into the stock. So the more interesting play for investors looking for opportunities in the "ambiance premium" would be to look at a firm selling lots of coffee but without the careful attention to ambiance that can lead to enhanced satisfaction and willingness to pay more.

    Denny's (DENN), for example (at least in my experience in stores across the West) has not fully tapped the ambiance link. However, in the transcript of the Q3 Earnings Call, the Denny's leadership acknowledges this in placing their 2014 focus and resources solidly behind remodeling of locations, a move that could lead to the ambiance premium (and pave the way for price increases) that Arielly has shown is part of the experience and psychology of the transaction.

    Armed with this research based insight, that consumers will pay more for the same coffee with simple/minor ambiance enhancements, investors can even do some of their own independent research by stopping by ambiance laggards in the food and drink industry or checking up on ambiance leaders, ground level research as important as reading the details in the annual report.

    Anchoring and Decoys

    Another possible link between consumer psychology and a real investment opportunity might emerge when investors study some of the research in Predictably Irrational about pricing and especially anchoring and decoys; these concepts apply to a wide range of products and services. But to continue the restaurant theme, price anchoring can be useful in a menu or other food/drink promotions.

    Firms like IHOP (DIN) have found the art of the menu "up sell" is a lucrative crucible mixing psychology and consumer preference as mentioned in businessweek. While this piece on the IHOP menu calls it a "Jedi mind trick", an effective pricing strategy and increased sales may also relate to how people often "anchor" on a initial price and then react to relative prices (38).

    Looking closely at a firm's pricing strategy could be fertile grounds for investment research. For example, Ariely, notes consumers rarely choose the highest priced option but frequently choose the second highest option (4). A food chain adding a high-end item on a menu may simply be using it as a "decoy" to get consumers to buy other upper-priced items.

    In the same vein on pricing, the notion of "free" is one of the most powerful pricing incentives (even when it turns out to be not so free). It consumes an entire chapter (Chapter 5) in Ariely's book. Whether it is a free FICO score on a Discover credit card (DFS), Amazon's free shipping (AMZN) or a common "kids eat free" in the restaurant industry, the "free" offer may drive consumers into higher margin products or to buy something when they otherwise might not. Investors should try to see how a firm's pricing (along with its products and promotion) in the marketing mix actually melds with current research on consumer psychology.

    More Recent Research: The IKEA Effect

    Another intriguing concept for investors from Ariely (and co-authors Norton and Mochon) is from a more recent 2012 article that reveals people place a higher value on items they assemble themselves. Hence the aptly titled name for this article and finding: The IKEA Effect. The phenomenon applies to both practical things like an IKEA storage box and decorative items like origami. And the implications extend well beyond the unique furniture store.

    Just add an egg--The DIY trend

    This IKEA Effect article begins by explaining how corporate America simplified the cake baking process in the 1950's to "just add water" and mix; however, housewives found it "too easy", so the solution was to add an egg (453). This is the general theme of the IKEA Effect--infusing labor can lead to the higher valuation of a product by consumers.

    This is not news to anyone who favors a homemade meal. And it is nothing new to anyone who has watched the amazing trajectory of DIY (Do It Yourself) in the US home improvement context. From one prominent show and guru in the 70's and 80's (Bob Villa on public television) to multiple networks, countless shows, and entire industries built on people working on their own homes (HD, LOW). The DIY trend tapped a rich vein of consumer preferences. But is it the money savings, the customization, or something else at work?

    IKEA Effect

    The Ikea Effect study bore out the notion that simply "adding labor" enhanced something about the product or experience. The results indicate adding labor enhances their value up to 63% over an identical item they did not assemble and people even prefer their item over a expert made item(455). With this finding, producers of all types of product should take notice--especially in a world of pressured margins and tough competition.

    There are some theories and ideas behind this concept. Of course, there is a customization approach--that you can add your own color, style variation or preference on DIY products--but this was not a factor in these experiments. And assembly can save money in some cases but this was also not a factor here. The labor and power to make things, alone, appears to trigger a higher valuation and/or ownership bias.

    Firms that recognize people are willing to pay more for something they have a role in producing could find ways to boost margins and differentiate products. Moreover, there could even be reduced labor costs (by shifting assembly to consumers). But the IKEA Effect is not without risks. That is, "some assembly required" can go wrong if people cannot complete a task (i.e., tab a does not fit into slot b). The result is frustration and the added valuation dissipates according to the article.

    Investors can be on the look out for new or existing companies that may be able to harness the IKEA Effect in a variety of areas beyond home improvement. Be it putting together your own furniture , a home improvement product, or building your own teddy bear (BBW), successful business models can be built on the concept.

    DIY Coke?

    Maybe the interesting question is whether the Ikea Effect can apply to products consumed daily--like soft drinks. There is already arguably a "look what I made" aspect to the Keurig coffee of Green Mountain ( GMCR); while light on labor, it does seek to bring the foamy, aromatic coffeehouse to your home. But what about DIY Coke (KO)? Isn't it easier and cheaper to just open the can (rationally, yes).

    Interestingly, a Yahoo Finance piece on the possibilitiess of Keurig and Coke notes DIY Coke would cost much more, but armed with IKEA Effect research--investors may be able to ponder if the enterprise may mesh with consumer psychology. This may be especially so if the price is more comparable and if Coke and Green Mountain can perfect the experience. While it may be irrational to pay more for a Coke you make at home--it may be predictably so.

    Disclosure: I am long DENN, SBUX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Additional disclosure: I own all of these stocks as top holdings in ETF's or in index or mutual funds.

    Tags: AMZN, BBW, DENN, DIN, GMCR, HD, LOW, SBUX, KO, long-ideas
    Feb 21 5:28 PM | Link | 2 Comments
  • Counter Trends to the Gray Dawn: Or Why it May be Further Away for Stock Investors
    Many of you may know of Petersons works (Gray Dawn and Running on Empty), books about troubling demographic trends.  The simple thesis is that an aging population can cause some major imbalances.

    This shows up in our underfunded entitlement programs, widespread state pension underfunding, and staggering health care costs for organizations and local and state governments. These trends seem pretty constant across developed countries, particularly those with low birth rates and an older population (Japan, Germany e.g.).

    The picture for investors is also painted in fairly bleak terms as well. For as these aging baby boomers begin to retire en masse, the fear is that they will head to the counter and cash in their chips (stocks, bonds, etfs, mutual funds, real estate, etc.) to pay for retirement.

    But the demographics in the US and other developed countries are such that there may be more sellers than buyers. The stock example seems abstract, but think about a business in your community (car dealers, stores, contractors, restaurants) and particulalry older owners. Are there enough young people you can think of waiting in the wings ready and able to buy these for market value?

    The same may be true when baby boomers seek to sell pieces of real companies--stocks. There may not be enough buyers--not just younger people but younger people with cash and the interest in the assets. Note: the unemployed twenty and thirty somethings living in their parents basement, for example, may be young but not bona fide buyers of boomer assets. So we have both an age and income imbalance.

    When there are more sellers than buyers--we usually see prices drop. But the end is not near yet (even though the first of the boomers have begin to retire and qualify for social security at an alraming rate). What is the takeaway for investors?

    Jeremy Siegel also talks about these same issues in his book The Future for Investors. One possibility is that the emerging markets (BRICs) may supply the younger investor class that will buy baby boomers' assets. Another possibility is that the immigration that many rail about can improve the balance, especially with affluent, highly educated and skilled immigrants. In addition, the US demogrpahic imbalance is not as bad as other countries (we can still seem to make babies even if the manufacturing base has eroded).

    My take right now, however, is that we have some time before the Gray Dawn causes too much weariness for stock investors. Low interests--signaled to be the regime for the near term--mean even income investors in retirement will need to seek out dividend stocks, many of which are paying more than government bonds.

    In addition, the average retiree at 65 can expect to love another 10-15-20 years or more. For that type of time horizon, stocks are one of the best hedges against inflation (claims on real asset) and will appreciate to retain the real value of portfolios and nest eggs.

    So the low interest rates lead income oriented investors logically to dividend stocks and increasingly long life expectancies lead logical investors to assets that outperform others over the long term and provide real returns over inflation: stocks again. Risk, of course, is a factor for retirees. But the risk of buying into bonds at historically low rates makes the prospect of bond funds or individual bonds at any rate beyond a short term, ripe with interest rate risks. CD's and other types of savings vehicles (including government bonds) are actually bringing negative returnes after inflation. So the risks for baby boomers may be in being out of stocks for the next few years.

    Eventually, baby boomers will sell off their assets to fund their retirements dreams andto  replace their incomes, but that may be a more gradual sell off than predicted, particularly for stocks. And the delay will bring more working age buyers of assets into the fold both in the US and from global and emerging markets, putting off the Gray Dawn for stock holders a little longer.

    (The crisis in the government entitlement programs related to this demogrpahic issue (social security and medicaid), however, need some more immediate incremental adjustments to remain viable)




    Sep 01 2:36 AM | Link | Comment!
  • Comfort Food For Thought: Soothing Investor Reading for Volatile Times

     

    This week had more ups and downs than the roller coasters my ten year old gets me on each summer.

     

    At such times, I find it more fruitful to pick up an investing book than at peak at my brokerage accounts. Here are just a few of my favorites, classics of the investment genre that I recommend as balm for the frazzled investor.

     

    The Snowball: Warren Buffet and The Business of Life by Alice Schroeder. This work on one of the greatest buy and hold investors of all time adds another volume to the Buffet canon. For times of great volatility, it is especially soothing to know Buffet's ideal holding periods for good companies is--well--forever. But you can also read how the young Buffet sold Coke as a child and delivered the Washington Post as a paperboy--companies he'd later invest heavily in. Buffet builds relationships with both companies and friends for life, a fact putting a week of folly in perspective. (Note: Roger Lowenstein's Buffet: The Making of American Capitalist is a shorter alternative with many of the same themes and biographical information; it may fit better in the beach bag, too).

     

    Stocks for the Long Run by Jeremy Siegel. This is still one of the most readable and well-researched books on the stock market for the popular audience. Siegel makes the rock solid case that over the long term (albeit sometimes the very long term: ten and twenty year rolling periods) stocks are tough to beat. This highly educational text also reaches back over a hundred years to examine actual stock market data, letting you see investors have been through this type of volatility (and even worse) before. Another buy and hold anthem for a wild week, Siegel's book reveals the folly of market timing and the value of staying the course with common stocks (oh, and reinvest the dividends, too--a key part of performance).

     

    The Little Book of Common Sense Investing by John Bogle. While primarily touting the benefits of indexing, Bogle offers his wisdom from a lifetime in the markets: primarily noting that you can't control them. This is a major reason he advocates index funds religiously. But the Vanguard founder has a hopeful message for troubled times in telling investors there are things they can control: their saving and investment rates, their asset allocation, and most importantly their investment fees and transaction costs. Indeed, the deepest plunges of the past week would pale in comparison to the slow but steady losses a long-term investor would face from not investing, from very high cost mutual funds, poor allocation, or excessive transaction costs. Now may be the time to look at what we as investors can control. These really matter the most over the long term.

     

    One Up On Wall Street by Peter Lynch. This classic book that brought many of today's investors into the stock market and initiated them into the analysis of individual stocks. Perusing this one again is not just a trip down memory lane or mere nostalgia, it can remind you why you are in the stock market in the first place. Readers can recall how they way it felt to study and buy your first stock, to walk into a store you actually owned (even if a minute fractional share). Following stocks is also a calling to ownership of corporate America and ultimately empowerment--no matter the erratic closing numbers this week. Investing is a mechanism that allows you to drive down the highway and see your stores, you vehicles, eat food from your companies, it can offer a deeper knowledge and connection to the world around you as well as yield profits.

     

     

    Michael L. Boyer is an Associate Professor at the University of Alaska-Southeast and is long all of these books and more.



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: All in the piece.
    Aug 13 4:32 AM | Link | Comment!
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