When EQ beats IQ – Investors’ Chronicle

When EQ beats IQ – Investors’ Chronicle

In his seminal work on behavioural science, Thinking, Fast and Slow, the Israeli psychologist and economist Daniel Kahneman recalls meeting with a fund manager who had just bought millions of dollars of Ford Motor Company (US:F) stock.

Asked to explain his bullishness, the investor describes the automaker’s recent trade show, and the positive impression it had left. “Boy, do they know how to make a car!” he says.

To Mr Kahneman, such thinking is a classic case of the affect heuristic, a decision-making process in which “judgments and decisions are guided directly by feelings of liking and disliking, with little deliberation or reasoning”. Responding instinctively to our feeling saves time, but as Mr Kahneman puts it, it also “creates a world that is much tidier than reality”.

For investors, the lesson here is well known, and well justified. Buying and selling with your personal preferences, going with your gut, or simply trading when you feel ecstatic or desperate is often tempting. But it also means downplaying the importance of fundamental analysis and the dry details of market competition, capitalisation, cash management and executive competence, which should provide the empirical basis for investment confidence. Put simply, liking the look of a car tells you nothing about whether its manufacturer’s stock is undervalued.

But there are limits to this theory. Why, after all, do some people prefer a Ford to a Reliant Robin, and vice versa? Many rational factors will help a consumer arrive at a decision to buy one or the other, but emotion plays a role, too. In recognising his own intuitive emotional reaction, the Ford-loving fund manager was acting and feeling the role of a customer, itself an intangible yet critical insight into the value of the company.

As it turns out, emotion dominates the investment process. The work that won Robert Shiller the Nobel Prize in economics – that share prices move far more than fundamentals can ever justify – is intuitively known to any day trader. Anyone who thinks the stock market is free of emotion need only reflect on the fact that Tesla (US:TSL) trades on 215 times forward earnings. Call it fear of missing out or religious-like fervour, the company’s value has left any rational planet, along with the wealth of its Mars-bound founder.

Understanding and even exploiting human emotion has also made successes of many businesses and their investors. Take Facebook (US:FB) and Twitter (US:TW), whose share prices have both beaten the 100 per cent gain in the S&P 500 over the past five years. Although there are increasing signs that the game might be up, the social media platforms have for some time owed a chunk of their success and brand power to their position as breeding grounds for outrage and controversy.

Initially marketed as venues for connected, open and civic discourse, both are now better known for monetising the opposite, with an addictive interface thrown in for good measure. Angry people click more, after all.

 

 

Social media aside, there are good reasons for investors to pay attention to emotion. Why? In short, because businesses think about emotion. A lot.

Although fundamental analysis should always serve as a first port of call, evidence of sales growth alone doesn’t explain why or how customers are drawn towards a product. To grapple with that, investors need to dig into the ways emotion is used by companies to build competitive advantage and market share.

 

Feeling secure

Although it has seemed in short supply for much of the past year, everybody wants and needs security. But though few have been able to hold their loved ones or count on having a job in six months’ time, the stability of the financial services sector has not been in question during the pandemic – save, admittedly, for the chaos of last March.

Touch wood – and with plenty of credit to an avalanche of monetary and fiscal stimulus – we haven’t seen the bank runs or state bailout of insurance giants that marked the most heart-stopping moments of the 2007-08 financial crisis.

This doesn’t mean a chain reaction of negative events cannot occur within the financial system, which like all systems will one day eventually fail. Look hard enough, and you’ll find any number of risks to keep you awake at night, from major cybersecurity breaches, to the unintended consequences of negative interest rates, a bubble in leveraged loans, runaway inflation, or a sudden crash in the liquidity of short-term lending markets.

But after more than a decade of improving regulatory standards and slowly rebuilding trust, security is no longer a prime concern for those using – or investing in – the financial services sector.

In small but important ways, this trust has been evident throughout the pandemic. Wealth manager Brewin Dolphin (BRW) posted its highest ever client satisfaction and net promoter scores for its financial year to September 2020. Lloyds Banking Group (LLOY) saw its customer deposit base climb 9 per cent to £447bn in the first nine months of 2020, as savers parked their cash with the UK’s largest high-street lender. Interim results for Aviva (AV.) showed a surge in the sale of new health and life insurance policies.

Each case points to a business in which customers placed not only their money but their faith during a period of considerable market turbulence and social upheaval. The same can be said of DIY investment platform provider Hargreaves Lansdown (HL.), which maintained its strong record of client and asset retention throughout the depths of the Covid-19 despair, all the while growing its customer base (see chart).

 

 

Critics, including this magazine, have pointed to the FTSE 100 group’s sometimes expensive fund pricing structure and income earned from cash deposits as examples of benefiting from client inertia. On another reading, Hargreaves has simply succeeded in helping its 1.4m-strong client base feel secure about using its investment platform, which for many people is more important than getting the most competitive price for a service.

But how does a company win this trust? “For me it starts and ends with positive brand awareness for existing and potential clients, whether that client comes on board next year or in the next decade,” says Nik Lysiuk, a financial services analyst at brokerage finnCap. In turn, this emotional attachment can act as an intangible inhibitor to sector competition. “Why would firms spend so much on marketing in the first place if it didn’t?” asks Lysiuk.

Some, including cryptocurrency believers, may scoff at the trust many people implicitly place in financial services providers. To them, the banking system is either run by crooks or umbilically tied to central banks’ ongoing currency debasement, or doomed to repeated crashes, or all the above. And perhaps they are right: security is an article of faith, not a law of physics.

But the alternative is to buy bitcoin, hope you remember your wallet password, and forget about consumer protection if its price crashes (as is its wont).

Like lots of supposedly libertarian thought, much of this anti-finance worldview is pure posturing. Although there are some reasonable arguments to hold cryptocurrency – and a growing chorus of major investors increasing their exposure to the ‘asset class’ – the risks involved are simply too much for most people to swallow. Wild speculation is not security.

None of this makes it easy to attach a value to client stickiness, unless an acquisition is made and booked as goodwill. But the strength – and occasional success – of financial services companies rests entirely on their ability to build trust. Once this is won, the opportunity to gear profits can be enormous, as Hargreaves has shown.

 

Worldly desires

Commerce, at its essence, involves people who want goods or services, and others prepared to sell those goods and services at a price. Beyond trust and quality, most transactions are dictated by two very basic parameters: price and the proximity of buyer to seller.

When placing an order for a shipment of iron ore, a steelmaker’s primary interest is to get the cheapest market price on a certain date. With the £20 in their pocket, a time-pressed single parent wants to buy as much food as they can from the corner shop. Neither is much concerned by the artisanal quality or presentation of the products they are buying.

But as you move up the hierarchy of needs, you ascend from the basic consumption of raw commodities to the ever-more rarefied air of consumerism, and to products sold to satisfy a complex array of psychological and emotional cravings. 

In recent times, the pre-eminent example of this is arguably the iPhone, which the late Apple (US:AAPL) co-founder Steve Jobs unveiled 14 years ago this month. Apple shares, then worth around $3, have since delivered a more than 40-fold return, in large part thanks to the iPhone.

The total ubiquity of smartphones in 2021 makes it hard to emphasise what a game-changer this product was when it first arrived. To many, the iPhone was the ultimate vindication of Mr Jobs’ obsession with the perfect fusion of software, hardware and user interface.

But the 1.5bn units sold to date also speak to Apple’s near-peerless ability to create desires that customers didn’t know existed. It’s all there in the iPhone’s unveiling at the MacWorld conference in 2007. To the whoops and applause of the Apple-loving faithful, Mr Jobs used the word “want” 37 times during the product’s launch, walking the audience through a laundry list of features they couldn’t have conceived of 10 minutes earlier.

It was at this point that Apple started to wear the taste-making halo of a luxury designer, without the exclusivity. Since then, from early adopters to global mass market, the iPhone has been marketed in increasingly more emotive ways, and as a shortcut to a more creative, stylish and aspirational self.

This isn’t a new insight. Fashion and the cultivation of taste has always been about conferring special status on some products. But building and maintaining customers’ sense of ‘have-to-have it’ compulsion is no easy task. Having a killer product is only one part of the equation; creating desire for it is an entirely separate job. This is where branding steps in.

“It’s really informative to look at brands,” argues Peel Hunt retail analyst John Stevenson. “No-one feels that strongly about consumer brands either way, but consumer sentiment is a massive part of why people buy things – it’s a two-way relationship.” It’s also notoriously hard to quantify, although many try. According to the consultancy Interbrand, Apple’s brand value is worth a third of a trillion dollars alone, or around a sixth of its market capitalisation (see chart).

 

 

Companies are also getting more sophisticated in their engagement. One of the more overlooked reasons for the demise of the High Street has arguably been the ability of companies to cut out the middle man and build brand awareness with customers online, where interests and likes can be scraped and mined for opportunities to shift more product more efficiently.

“There is a real shift to direct-to-consumer marketing,” says Mr Stevenson. “For a long time, wholesale used to be the way to come to market, as Ted Baker did when it initially launched in the US. Now you want to own the customer data and the direct distribution models, which makes it much easier to engage customers.”

Mr Stephenson gives the example of Boohoo’s (BOO) Black Friday online marketing push in 2019, which engaged one in five of the users it advertised to on Facebook. “That’s an off-the-chart response to paid social media,” he says. “This is the sort of data that fund managers and professional investors are looking for – it’s this resonance with the consumer that means you know they’re going to deliver growth.”

A keen appreciation for customers’ emotional reactions certainly seems to be behind the recent success of The Hut Group (THG), the e-commerce company that has risen 51 per cent since it listed in London last September. Fourth-quarter sales for its beauty division, the group’s largest, shot up 66 per cent to £298m as buyers flooded its websites with orders for heavily-discounted cosmetics and beauty products.

Exclusive deals with producers are an important part of the formula here. But so too is marketing, which is spearheaded by a small army of social media influencers to provide a personal connection. Presentation is also key. THG subsidiaries Lookfantastic and Glossybox have both had enormous success with their mystery box subscriptions, whereby customers are sent a range of unseen beauty and skincare products and samples.

Scroll through the myriad unboxing videos on Youtube, and you’ll see this sales channel for what it is: a canny way to make subscribers feel like it’s their birthday once a month. It’s a service they pay for, of course, although this hardly invalidates the sales method. After all, feeling special, rewarded or excited is exactly what self-care products are designed for anyway.

 

Emotional escape

How do you get away from it all when you can’t go anywhere? When lockdowns swept the world last year, many people instinctively knew the answer to that question.

Computer games command an enormous amount of our collective time. According to Deloitte’s latest digital media trends survey, recorded before Covid-19 struck, 24 per cent of respondents listed playing video games among their top three favourite entertainment activities. Among adults born between 1983 and 1996 it was 37 per cent, and 44 per cent for those born after 1997.

Since the pandemic’s onset, Deloitte cites estimates that time spent gaming has risen by 75 per cent, meaning some core audience groups are likely to be playing an average of two hours a day, if past data surveys are accurate (see chart).

 

 

Despite this, video games’ increasing cultural dominance is scarcely reflected in traditional media, in part because it defies easy translation, but also because it is poorly understood. Conversely, the Oscars or Emmys still receive blanket coverage as if everyone is expected to have a cultural stake in mainstream cinema and music.

That’s odd, because the combined time spent playing the major video game releases of the past year – among them The Last of Us 2 from Sony (Jap:6758) subsidiary Naughty Dog, Activition Blizzard’s (US:ATVI) Call of Duty series and the Ubisoft (Fr:UBI) production Assassin’s Creed: Valhalla – are likely to have far exceeded the collective attention commanded by the most high-profile films.

The investment case in video game developers also tends to focus on their ever-diminishing costs of distribution, and their ability to launch wildly popular titles to fanatical customer bases. Companies such as Frontier Developments (FDEV), maker of construction and management simulation games like Rollercoaster Tycoon, have proved adept at constantly reformatting, expanding and upgrading long-running series.

But to caricature video games as products that are merely passively or addictively consumed underplays their emotional power, and the jaw-dropping craft that results in players fully immersing themselves in alternate realities. Seen through this lens, the industry sells not just entertainment, but forms of therapy, community and even travel.

Indeed, for many top action-adventure games, the storytelling is on a par with great literature and cinema, providing not simply escape from a challenging real world – as it is sometimes portrayed – but a medium through which gamers are invited to both empathise and self-identify.

According to FactSet, the major listed video games sector trades on 29 times next year’s earnings. With such a shrewd appreciation of emotional response, and a proven ability to captivate, it’s tempting to view that as cheap.

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