I recently finished reading an interesting book called The Halo Effect by Phil Rosenzweig. The premise is straightforward but powerful: most of the things that people think contribute to company performance are actually attributions based on performance.
An example makes this distinction intuitively clearer:
Barry Staw, then at the University of Illinois and later at the University of California, conducted an experiment in which groups of participants were asked to estimate a company's future sales and earnings per share based on a set of financial data. Afterward, he told some of the groups that they had performed well, making accurate estimates of sales and earnings per share, and told other groups they had performed poorly - but Staw did so completely at random.
In fact, the "high-performing groups" and the "low-performing groups" had done equally well in their financial calculations; the only difference was what Staw told them about their performance. Then he asked the participants to rate how well their groups had done on a range of issues.
The results? When told that they had performed well, people described their groups as having been highly cohesive, with better communication, more openness to change, and superior motivation. When told they had performed poorly, they recalled a lack of cohesion, poor communication, and low motivation.
Staw concluded that people attribute one set of characteristics to groups they believe are effective, and a very different set of characteristics to groups they believe are ineffective.
The book then delves into countless examples of the Halo Effect in action:
- When Cisco was performing well, it was described as a "focused, disciplined company, making a science out of merger integrations." After its stock price plummeted during the dot-com bust (for reasons largely outside of its control), it was described as having "been on an 'acquisition free-for all' characterized by 'haphazard' and 'freewheeling investment practices.'"
- When ABB (a Swiss-Swedish multinational corporation) was posting record profits, its CEO, Percy Barnevik "had been the focus of a virtual personality cult, portrayed with powers of a superman. He had been described as charismatic, bold, and visionary. But once performance fell, Barnevik was remembered as arrogant, imperial, and resistant to criticism."
- "Financial performance, measured by return on assets and earnings per share, has a more powerful effect on employee satisfaction than the reverse...being on a winning team is a stronger cause of employee satisfaction; satisfied employees don't have as much of an effect on company performance"
- Companies that successfully diversify are praised for their ingenuity, while those that fail in their diversification efforts are criticized for "lack of focus."
The reality is that business performance is uncertain, complex, ambiguous and probably more reliant on luck than most people care to admit. But the desire for journalists, financial analysts and management gurus to neatly spin things into a coherent narrative often confuses cause and effect, and history is frequently rewritten to justify performance after the fact.
What implications does this have for investment strategy and performance?
First, there are also some important implications for investor psychology. When a stock price goes up, it's natural to pat yourself on the back and look more favorably upon the business prospects of the company. Similarly, when the price goes down, it's easy to second-guess yourself and view news and management in an unfavorable light (even though nothing about the business has fundamentally changed). Both of these feelings confuse price with value, and reinforce the lesson for me that it is important to have some fundamental baseline of value (i.e. a discounted cash flow valuation) to fall back on, to combat these powerful biases.
Second, I am much more skeptical of explanations for failure or success. By definition, most "value" stocks are priced below their peers due to a variety of disillusionments, and there are no shortage of pundits who claim to know the secrets of under-performance. In the end, most of this "analysis" is likely noise. The challenge (and the opportunity) is in identifying which "negatives" are truly fundamental, versus those that are due merely to the Halo Effect.