Executive psychology can impact financial results

Most investors can recall a time when they’ve fallen victim to their own psychology. For instance, many have held a stock for too long, making their loss bigger or their gains smaller.

Why does this happen? Let’s take a look.

The endowment effect

Part of the reason behind an investor’s behaviour comes down to the endowment effect, which is simply the tendency of people to value a good they already own at a higher amount than they would pay for it. One experiment involved the trading of coffee mugs. Half the people were given mugs, while the other half were not. When it came time to establish a value for the mugs, those who owned them set the offer price at twice what those without the mugs were willing to pay. Other experiments have shown an even greater disparity between the so-called willingness to accept and the willingness to pay. The creators of the experiment, led by Nobel Prize winner Daniel Kahneman, credited the behaviour to the idea of loss aversion: people fear losing their belongings.

It would seem to go beyond human nature and is even hardwired into our brains at a basic level, with the effect showing up in monkeys as well.

While the impact of behavioural tendencies is widely discussed in the investing world, it’s rarely mentioned in the accounting world. So, what impact does the endowment effect have on executives? Beyond the transactions they make, or the opportunities they miss, company management is responsible for making assumptions that impact the reported value of the company’s assets and income every quarter.

Why does nobody suggest we take the psychology out of accounting? Rather than fixing the problem, accounting has actually moved in the opposite direction in recent years. IFRS has made accounting more fraught with uncertainty and more open to the influence of the endowment effect. Two major themes of IFRS remain a concern, as they relate to potential pitfalls of executive psychology.

1 IFRS promotes the importance of the balance sheet, making it the primary focus even at the expense of making the income statement less reliable.

Management is now tasked with fair-valuing or marking-to-market assets, with the consequence of recording unrealized gains on the income statement. Because the assets aren’t being sold, but instead are being revalued every quarter, the endowment effect has a greater influence because executives will tend to overvalue their own assets.

2 IFRS is principles-based, as opposed to rules-based.

Since rules tend to be more objective, and principles more subjective, it worsens the potential impact of the endowment effect. IFRS pundits tend to lean heavily on the idea that management knows its company and assets best, allowing them to value the assets as they see fit, instead of holding them accountable to prescriptive rules for valuation.

This marks a separation from the endowment effect as seen in investors, who overestimate the value of their investments before reality intrudes on a timely basis.

By contrast, while executives have the ability to ascribe higher values in the financial statements, it could be years before the market becomes aware of any overvaluation (because an actual sale might not occur for some time).

What investors can do

Investors should identify which industries could see the greatest impact from the endowment effect on reported financial results. Both the accounting guidelines and the general valuation metrics used by the market combine to determine what sectors are most at risk.

The issue comes up frequently with REITs, energy companies and conglomerates that hold a variety of investments. Within the REIT sector, there is often reliance on net asset values, which are derived directly from the balance sheet. Sometimes, investors will focus on a company that’s trading at a discount to its reported NAV.

They believe the gap will naturally close, producing an increase in share price. However, that belief can be wrong and costly if evidence surfaces later that a company made unrealistic assumptions about the value of its real estate. Investors need to concentrate on whether the company has recorded losses on previous asset sales, which is a red flag with respect to the reliability of management estimates. For instance, two apartment property owners (CAPREIT and Milestone Apartments REIT) reported losses on actual property dispositions in 2015, while reporting significant unrealized gains on the rest of their portfolios, based on management assumptions.

The same issue can exist in the energy sector when companies report their annual reserve results, which determine the assumed value of their resource base. These assumptions work their way into target prices, and can create unrealistic expectations for investors.

Conglomerate companies that combine several private-equity investments can be especially vulnerable to the endowment effect because it’s difficult to value diverse and sometimes non-comparable private-company investments. Difference Capital is an example. In its first six months of 2015, it recorded a loss on the disposal of certain investments and marketable securities of $8 million. This was offset by an unrealized gain on other investments and marketable securities of $12.2 million, to produce a reported net gain of $4.2 million for the period.

So, clients should be aware of which industries are vulnerable to the potential impact of the endowment effect in executives. The objective way to check management valuation assumptions is to be mindful of the outcome of actual asset dispositions, and whether they support the unrealized gains reported in financial statements.