Anchoring Bias: An Opportunity in Innovation Investing
The Anchoring cognitive bias in psychology is well understood, and very simple. It refers to the basic psychological bias when a human’s assessment of any value-judgment is influenced by an arbitrary data-point that distorts expectations vis-a-vis the original thing being assessed.
For example, if I’m considering buying a hoodie from one of those overpriced “postmodern” millennial brands for £150 (or even more if there are no capital letters in the branding), the probability of my concluding ‘yep, that’s good value for money’ is really very low. If, however, I saw on the label that the original price was £250 and the current price is “discounted”, I now anchor my assessment of the value for money on that new £250 data point, and might now be slightly less likely to say no to the new price tag.
There is no end to the ways Anchoring bias distorts impartial judgment. From the child of a Prime Minister who is perennially disappointed with their own successes, to the Manchester United supporter who still thinks they can compete for the title.
Things get interesting when we think of its impact in investment decisions and valuations. As investors we always try to remember that the market is not just a collection of spreadsheets, but a collection of people and their opinions. To say market prices embed psychological biases would be a tautology.
Anchoring creates pockets of inefficiency that can be seized upon by the long-term investor, and while there are many areas of opportunity, the one that has stood out to me recently is the world of Small & Mid Cap Innovation investing. By “Innovation” I refer to innovative companies with high levels of R&D and IP, often in the areas of software, medical technology, industrial technology, amongst others. Such companies make up the holdings of the Montanaro Global Innovation Fund.
Broadly speaking, there are three common ways to invest in Innovation companies. The first is the large caps, from the FAANGs (Facebook, Apple, Amazon, Netflix, Google – but we should add Microsoft, too) to Roche and Pfizer. The second is quoted Small & Mid Cap companies like ours that are of a certain scale, typically global leaders in their niches often with tens or hundreds of millions in sales and excellent unit economics. And the third is emerging startups through venture capital.
Leaving aside the mega caps like Microsoft, because we have never argued that large caps shouldn’t be part of your portfolio, let’s compare the other two.
The Anchoring biases we see in our Small & Mid cap universe, compared to venture capital, are often diametrically opposed.
When a venture capital investor values an exciting startup with negligible revenues and one exciting high growth potential product, they use a top down analysis to anchor their expectations, based on the Total Addressable Market (TAM) their hopefully-disruptive product is going after. What is the total size of the market they’re going after? 100bn? That’s their potential. Let’s assign a probability to their achieving that, and, hey presto – we have our funding round valuation. Here, the Anchoring bias is tied to top-down analysis.
Whereas when an analyst values an established, successful business with a portfolio of products in the public markets, as is the case in the world of Quality quoted Small & Mid caps, the valuation models are bottom-up. This means looking at a company’s portfolio segment by segment, looking at the historic growth, and building a discounted cash flow model to create a bottom-up valuation judgment.
So while the venture capital investor anchors their expectations on the size of the eventual pot of gold at the end of the rainbow, the public markets investor anchors their expectations to the company’s existing track record and historic numbers.
Herein lies our opportunity.
There exist out there highly innovative public companies of a certain size and maturity in the Small & Mid cap market cap ranges, that every now and then invent totally new IP and roll out radically novel disruptive products, often in entirely new markets to the ones their existing products address.
When this happens, unlike in the venture capital world where every product and startup with promising IP is seen as a hopeful Unicorn, the public market anchors its expectations to historic numbers.
There is a lot of money to be made when those expectations anchored to historic numbers get smashed by something totally new.
Let’s be specific with an example. Taking you back to May 2020, in the depth of the pandemic, Montanaro took a position in Bruker, the Life Sciences instruments company. Bruker is a sizeable market leader in the global segment of the scientific instruments market (for example Nuclear Magnetic Resonance, Raman Microscopy, and Maldi-Tof Mass Spectrometry).
In our research, we found that Bruker had invented a totally new technology platform within Mass Spectrometry that was fundamentally disruptive in its application and technology. We’re talking totally new IP. They called it the Tims-Tof Mass Spectrometer, based on Trapped Ion Mobility technology which Bruker coupled with Time of Flight technology to create the first Mass Spectrometer in the proteomics research market that could rival Thermo Fisher’s Orbitrap for sensitivity and resolution, but radically outgun Thermo Fisher’s instrument in throughput.
Bruker was a global company of around $6bn market cap at the time, with decades of history, but a recent history of only mid-to-low single digit organic growth.
Bruker invented the Tims-Tof in 2017, and quietly started commercialising it in 2018 and 2019, but it was still barely moving the needle on top line growth for the entire group, and so the investment banking community, knowing nothing else, continued to forecast Bruker’s growth to be in the mid-single digits for the next half-decade. They were anchoring their growth forecasts to the historic numbers (based on years when the Tims-Tof didn’t exist), overlooking the new IP.
Fast forward to the end of 2021, and the Tims-Tof technology alone is already contributing a run-rate of nearly $100m annually from a standing start, and along with some other new product lines has helped nearly double the organic growth expectations for the Bruker group going forward from around 5% to closer to 10%, driven largely by the Tims-Tof continuing to grow 30%+ into the future.
As the market smelled the coffee, Bruker’s shares got a rerating, and those investors who were able to overlook the sell-side’s initial Anchoring-based pessimism were rewarded handsomely.
This is a long game, and you can be sure that there are newer-still products in the Bruker portfolio that the sell-side still has no idea how to model.
Bruker’s Tims-Tof platform is just one example of the rich opportunities afforded to us in the Global Innovation Fund by the market anchoring its expectations to historic data, which, in the case of fundamentally new IP, represents an arbitrary, irrelevant data point.
The simple point is that Quality Growth Small & Mid Cap stocks give an investor the best chance of capitalizing on the Anchoring Bias in Innovation. When it comes to a large cap company with $10bn in sales, an exciting new product that can one day contribute $100m won’t make a huge difference. When on the other hand one considers venture capital, let’s just say that your Anchoring risk is usually the other way round: that investors anchor to an inflated TAM estimate and end up holding the hot air between that number and the humbling reality of the intense competition between start-ups.