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A Few Notes on The Halo Effect

Posted in Fundamental Valuation, Sentiment Indicators

In his 2007 book, The Halo Effect …and Eight Other Business Delusions That Deceive Managers, Phil Rosenzweig argues for distinguishing carefully between sentiments (halos) derived principally from past bottom-line performance and fundamentals independent from that performance when assessing the excellence of companies and managers. Sentiments are essentially opinions expressed via “managers’ ex post facto recollections, company statements, and articles from the business press.” The distinction between sentimental and fundamental is important for investors/traders, as are his related conclusions about the value of experts and the inherent unpredictability of firm performance. Based on his review of prominent past studies of business excellence, he finds that:

From page 34:

“There’s a natural tendency, even at leading publications such as Fortune and Business Week, to exaggerate highs and lows, and to rely on simple phrases to explain a company’s performance…these journalistic accounts become the primary sources for later studies.”

In other words, the media employs mostly sentimental shortcuts in assessing company performance, and the sentiments expressed are much more reflective of past trends than future performance.

From pages 86, 98 and 105:

During the five years (1980-1984) after publication of the sentiment-based In Search of Excellence by Tom Peters and Bob Waterman, only 12 of the 35 publicly traded “excellent” companies outperformed the S&P 500 index. And, 30 of these 35 companies showed a decline in profitability (operating income as a percentage of total assets) over this period. During the ten years (1980-1989) after publication, only 13 of these 35 companies outperformed the S&P 500 index.

During the five years (1991-1995) after completion of research for the sentiment-based Built to Last by Jim Collins and Jerry Porras, only eight of 17 publicly traded “visionary” companies (so identified in the book based on extraordinary past performance) outperformed the S&P 500 index. And, only five of 17 improved their profitability over this period. During 1991-2000, only six of 16 publicly traded and surviving “visionary” companies outperformed the S&P 500 index. Moreover, 12 publicly traded “comparison” companies (so identified in the book based on good but not extraordinary past performance) outperformed their “visionary” counterparts.

“Suggesting that companies can follow a blueprint to lasting success may be appealing, but it’s not supported by the evidence.”

In other words, measures of sentiment may tell good stories, but they appear to lack predictive power.

From pages 138-139:

“Our desire to tell stories, to provide a coherent direction to events, may also cause us to see trends that do not exist or infer causes incorrectly. We may ignore facts because they don’t fit into our story.”

“…[C]ompanies that have outperformed the market for long periods of time are not just rare, they are statistical artifacts that are observable only in retrospect.”

“We may look at a handful of extraordinarily successful companies and imagine that doing what they did can lead to success, when it might in fact lead mainly to higher volatility and a lower overall chance of success.”

In other words, simplified frameworks for explaining the past are probably less useful for prediction than dispassionate statistical analyses.

From pages 173-174, some points to remember:

“If independent variables aren’t measured independently, we may find ourselves standing hip-deep in Halos.”

“If the data are full of Halos, it doesn’t matter how much we’ve gathered or how sophisticated our analysis appears to be.”

“Success rarely lasts as long as we’d like – for the most part, long-term success is a delusion based on selection after the fact.”

“Any good strategy involves risk. If you think your strategy is foolproof, the fool may well be you.”

“Chance often plays a greater role than we think…”

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