Good company, bad investment: The thinking behind investor decisions

May 25, 2021
It can be hard for management to understand why investors choose to sell their company’s stock

The executives of listed companies are often so convinced of the greatness of their management and strategy that they always see value in their company. Given this, it can be difficult for them to understand why an investor doesn’t buy a stock – or chooses to sell it.

The work of investors isn’t to decide whether a company is good or bad, or whether they like the executives. Their work is to discern whether buying that share will generate returns. By understanding the factors that influence investor decision-making, companies can have a better relationship with the market.

A key element is the investor’s time horizon. Normally an investor will evaluate a company based on a 12-month view. Even if there is no debate about the long-term value of a company, it’s not always possible, over a 12-month period, for the business to fulfill market expectations and see the share price rise.

Indeed, investors are becoming even less patient with companies. The average holding period of a stock has been dropping for many years – and in 2020 it hit a new low. A study by Reuters of NYSE companies found the average holding period is now five and a half months, compared with 14 months in 1999 and five years in the far-away 1970s. Over recent years, falling brokerage fees and higher volatility have accelerated the short-termism of investors.

Active investors are not only holding for shorter time periods, but are also trimming their portfolios. The growth of passive investment, with its low commission fees, has put additional pressure on active managers, which need to concentrate and rotate positions to lock in profits and justify their higher charges. As a result, the number of shares in a typical portfolio has fallen by half in recent years, from 120 to 61, according to data from Inalytics.

Liquidity is another key factor that affects investment decisions. Given the possibility that clients will choose to withdraw funds, investors want confidence they can get out of positions quickly.

A further consideration for fund managers is how they are assessed. An investor must not only invest in shares and hope they rise in value, but must also demonstrate their ability to outperform their fund’s benchmark on an ongoing basis.

The worst scenario for fund managers isn’t simply that they buy a share that falls in value. The bigger concern is that, while that investment falters, other shares they didn’t pick go up. This amplifies poor relative performance. Fund managers must select opportunities that do as well or better than other options.

In addition, managers always have in mind who will be the marginal or incremental buyers of the shares they own. If a company needs a major investment of time to be understood, trades at a high multiple or lacks a well-defined dividend policy, it may be hard to find generalist investors willing to buy the stock and keep the price rising. That can put investors off.

No less important is the subjectivity of investors as individuals. Their reputation, as well as their salary, is at play in the decisions they make. A bad period of performance versus the benchmark is going to create pressure from clients and superiors, and this will eventually lead to the sale of certain shares. The likelihood that a manager will buy one of those shares again, even if it appears cheap, is very low over the short term.

With all this in mind, companies must always work to create confidence with shareholders. They need to communicate consistently and build strong relationships regardless of whether, at a particular moment, an investor is ready to buy the shares. That way, they will be in a strong position when conditions turn in their favor.

In the stock market there is always a price to buy and another to sell. There is nothing better than investors that sell an investment and are happy with their gains. They will return.

Ricardo Jiménez Hernández is a partner at Sigma Rocket and a former director of investor relations at Ferrovial. This article was originally published in El Economista (in Spanish)

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