Morningstar Magazine - June/July 2018 - 9

circuits danced-inform the bees of the location
and quality of the sites. Over a couple of days, the
scout bees narrow down the choices. When a site
has won over about 15 scout bees, a quorum has
been reached. The other scout bees get on board
with the choice. The swarm is led to their new
home. Seeley found that this process continually
led the bees to pick the best site for their hive.
The collective intelligence of a swarm of bees is
able to harness independent evaluations of
sites to find the best outcome. Seeley describes
this as the right mix of interdependence and
independence.3 Nature has found an optimal mix
of the two through evolution.
Independence Lost

Scientists have tested a similar phenomenon
in humans based on music downloads.4 In this
experiment, people downloaded and rated songs.
One group was provided the songs to download
to evaluate independently, while a second
group was provided aggregate download
information indicating how popular each song was.
The bad news for the human subjects was that
they failed the independence test that bees have
mastered: The group with the download
information was heavily swayed by the crowd. The
less independently people behave, the more likely
they mimic the behavior of others. This is herding.

rises among investors still in the market, such
that there are fewer types of investors but more
widespread ownership by the majority. Here,
the idea of "markets as effective price setters"
comes under pressure as more like-minded
investors use similar decision rules, influenced by
each other and not offset by other investors.

to use a checklist.6 The one that follows isn't
exhaustive-other important items like liquidity,
issuances, and short positions could also be
considered. But it's a good start. We look for:
1 Concentrated ownership and unbalanced

investor flows.
2 Negative cash flows or earnings expectations

The key loss of breadth, in our opinion, is the loss
of a particular type of investor, a group that
includes value investors, rebalancers, option
sellers, liquidity providers, and contrarians. These
are the more price-sensitive and countercyclical
investors-they tend to sell after prices rise
and buy after prices fall. They also tend to be the
agents of negative feedback,5 helping to keep
prices in a rough band around intrinsic values.
As the types of owners dwindle, the size of the
remaining ownership per shareholder rises, and
investors start to synchronize at scale, behaving in
similar ways. This leads to crowding, herding,
mispricing, and fragile markets. Influence gives
way to replication. Rising prices lead to increased
trading activity, forming a positive feedback
loop. The situation becomes less stable as the pool
of potential buyers declines.

Back to investing: When like-minded investors buy
the same asset for the same reasons, investors
with different views sell. When buyers outnumber
sellers, prices rise. Rising prices eventually destroy
the diversity of investors, which Mauboussin refers
to as a movement from the wisdom of crowds
to the madness of mobs. Investors err in the same
direction, and contrarians look to take advantage.

In bubbles, fewer types of investors remain in
the market, while the number of investors willing
to own the asset at the current price rises.
This is where the concept of narrow breadth, or
crowding, can be misleading. The great bubbles
involve widespread ownership. The contrarian
minority mainly sits it out, with a limited number
taking the other side. All bubbles require a loss of
diversity or synchronization of investors. As
markets are adaptive, investors receive positive
rewards from the markets for their behavior.

Synchronicity

A Contrarian Checklist

An interesting dynamic occurs when the breadth
of investor types narrows. The depth of ownership

When dealing with the complexity of investing,
market efficiency, and behavioral biases, it helps

relative to history and similar assets.
3 Negative sentiment as gauged by investor surveys.
4 Low trading volume or turnover.
5 High and rising realized and implied volatilities.
6 Low valuation ratios relative to history and

similar assets.
Looking for Mispricings

Crowding, herding, bubbles, and crashes are
evidence that investors are not always rational and
markets are not always efficient. The infrequency
of these events highlights that markets generally
do a pretty good job pricing assets. But when
diversity declines and large groups of investors
synchronize, it's time to look for mispricings. As
contrarian investors, we tend to be in the minority,
both when markets are overpriced and oversold.
But being contrarian for the sake of being
contrarian is as likely to lead you into investment
errors as it is to get you booted off invitation
lists for parties. Just because something is
unpopular doesn't make it a good investment.
Combining contrarian thinking with in-depth
fundamental analysis and estimated intrinsic value
is critical. The best investments are often those
that are out of favor because of serious but
temporary and recoverable issues. Searching in
unpopular areas of the market certainly doesn't
guarantee success, but we believe it is a good way
to find opportunities. K
Daniel Needham, CFA, is president and chief investment
officer with Morningstar Investment Management. He
is a member of the editorial board of Morningstar magazine.

3 List, C., Elsholtz, C., & Seeley, T.D. 2009. "Independence and Interdependence in Collective Decision Making: An Agent-Based Model of Nest-Site Choice by Honeybee Swarms." Philosophical
Transactions of the Royal Society B, Vol. 364, No. 1518, pp. 755-762.
4 Salganik, M.J., Dodds, P.S., & Watts, D.J. 2006. "Experimental Study of Inequality and Unpredictability in an Artificial Cultural Market." Science, Vol. 311, No. 5762, pp. 854-856.
5 Unlike a positive feedback loop, aka the snowball effect, a negative feedback loop creates stability by keeping things from getting too far from the norm, like a thermostat adjusts the
temperature of a room. When markets are efficient, some investors enforce negative feedback through selling fully priced or overpriced assets and buying underpriced ones. Diversity of
investor types ensures diversity of opinion and approach.
6 See also Gawande, A. 2009. The Checklist Manifesto: How to Get Things Right (New York: Henry Holt & Co.).

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Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018