“Behavioral finance” delves deep into the psychological—and often irrational—factors that drive stock market performance. Not surprisingly, this evolving field of study has confirmed what many of us already know—that investors are often their own worst enemies. But if you understand the illogical traps that plague all of us, says Ralf Scherschmidt, you can put that to profitable use. Ralf and his team at Oberweis International Opportunities (OBIOX, 800-245-7311) certainly have. By taking advantage of what’s known as “post-earnings announcement drift,” or PEAD, Ralf and his team have amassed an enviable record: an annualized return of 21.9 percent during the past three years. Below, Ralf explains why it pays to heed PEAD.

How do you apply the theories of behavioral finance to investing?

Most people have been taught that investment markets are efficient at all times, and when there’s an anomaly, it gets arbitraged away pretty quickly. But there’s a persistent anomaly called “post-earnings announcement drift” (PEAD), which is usually not immediately arbitraged away because of human nature. It’s this anomaly that we take advantage of.

What happens is that analysts and investors do a lot of research on companies and get to know them pretty well: the management team, its prospects, its competitive positioning and all that good stuff. So they develop a belief about what the company can do in terms of revenue, margins, earnings, growth rates and cash flow. They then derive a present value for the future cash flow (discounted cash flow analysis) to come up with a valuation for the entire company, including price per share.

But the world doesn’t stand still. Companies are always changing, and some are completely transformed due to new products or technologies. Other transformational events include geographic expansions or restructurings. In many cases, investors understand the changes and update their projections quickly to come up with new valuations. But this doesn’t happen every time.

Many times, the market is slow to understand the changes. And at some point during this transition period, the company is bound to come out with an earnings release.

When a company’s fundamental change is significantly more positive than people expect, this leads to positive earnings surprises. A positive earnings surprise is just another indication that the market doesn’t yet understand or believe a business’ new fundamentals; otherwise, the market wouldn’t have been surprised in the first place.

So that disbelief is what’s driving PEAD?

Yes. According to traditional economics, the assumption is that as new information is released, every investor instantly understands the changes, updates his/her beliefs about the business, and the share price adjusts to true intrinsic value.

Well, PEAD has been tested, and we now have empirical evidence that the adjustment period can take many months or even years. This lag creates a window of opportunity for us to identify promising stocks after they post a quarter or more of positive earnings surprises.

How do you use PEAD?

Investors tend to have entrenched opinions, estimates and beliefs about things like revenues, margins and cash flows. It can take a very long time to change or do away with these beliefs given new information.

By the way, this unwillingness to change what we think we know is called “anchoring to numeric estimates.” Anchoring occurs when almost any entrenched belief is challenged. When Galileo presented indisputable evidence that the earth revolved around the sun, for example, he was jailed!

After we spot companies affected by PEAD, we conduct fundamental research, which is really very similar to what other bottom-up investors do: getting to know the company and its management; talking to suppliers and others in the value chain; understanding the changes the company is undergoing. Then, we come up with our own estimates of what future cash flow is likely to be.

When our projections are significantly different from the consensus estimates, then that’s a really interesting opportunity. If we’re right, then over time people will realize the company’s earnings prospects are much higher than they thought. As they adjust their beliefs and cash flow estimates upward, the share price tends to follow.

How do you gain conviction to go against the crowd?

For one, we start from a clean slate. Often, when we come across a company that stands out in one of our screens, we’ve never looked at that company before. Precisely because we aren’t starting with preconceived notions, we can much more objectively look at the information.

Secondly, we have studied mental pitfalls extensively, which helps us to overcome them. We often find ourselves initially reacting to a news item just like any other investor would. But because we have studied psychological and behavioral finance for so long, we’re able to step back and realize that our initial gut reaction might not be the right one.

What concrete steps can be taken to overcome emotional biases?

In March 2009, when fear was highest, people kept selling even though that’s precisely when they should have been buying.

You can overcome the strong emotion to sell when things look dire. The best way to do this is to have a plan and stick to it. For instance, by planning to put a percentage of your salary into the market every month, no matter what the market is doing. That’s taking advantage of dollar-cost averaging.

In the long run, dollar-cost-averaging will work out better than trying to time the market. It’s a very simple, time-tested strategy, but you’d be amazed how many people have trouble with it in the stress of the moment.

How do biases play out when it comes to sectors and companies?

We find that a herd mentality can develop across whole sectors or countries, so an entire sub-segment of the market can get frothy. The 3-D printer segment is one recent example of frothy valuations driven by everyone wanting in, regardless of the fundamentals.

What companies do you find interesting now?

One is the French telecom giant Alcatel Lucent (NYSE: ALU). It makes equipment and provides services for public and private communication networks. It did well in the late 1990s during the tech bubble. But Alcatel has suffered since then, as competitors such as Juniper Networks (NYSE: JNPR) have started to offer better equipment.

Like almost all of our ideas, Alcatel popped up in one of our positiveearnings- surprise screens. New CEO Michel Combes came in this past February to turn around the business. He used to run Vodafone Group’s (NSDQ: VOD) European operations, where he helped in the recovery there. So he has some operational experience. In fact, Vodafone Europe is now a leader in countries such as Germany.

Combes is overseeing a restructuring that includes spinning off or selling underperforming divisions. He is refocusing on segments in which the company is doing well and is in the top three in terms of market share. This includes areas like IP routing and optical networks. He’s also working to fix the balance sheet by targeting cost savings of at least $1 billion in two years, raising another $1 billion from asset sales, and refinancing $2 billion of the debt.

We believe Alcatel’s EBIT earnings for 2015 [earnings before interest and taxes] will be a little over EUR1.07 billion vs. the EUR640 million consensus estimate. If our thesis works out, the markets will recognize that a real turnaround is happening. At that time, estimates will be adjusted upward, and hopefully the share price will follow.

What else do you like?

We also like a Japanese company called ValueCommerce (Tokyo: 2491). As with most of our ideas, we noticed the stock after it had a very positive earnings release. ValueCommerce runs one of the largest and highest-quality Internet marketing networks in Japan. Basically, ValueCommerce connects advertisers (some 2,000) with website publishers (some 930,000). The benefit to the advertisers is that ValueCommerce gets paid only when the ad works—people make a purchase.

ValueCommerce was the first company of its type in Japan. Its services are a great way for advertisers to enter the Japanese market. It also offers ad tracking and analytical services, and it is one of the most costefficient companies out there.

Japan accounts for 55 percent of total Asian retail spending, and it is world’s second-largest online retail market.

The stock market hasn’t quite figured out the true growth rate of ValueCommerce. Our earnings per share estimate for 2014 is JPY90, while the market consensus is currently at JPY70, an almost 30 percent difference.