Simon and Garfunkel is my favorite band. They, especially Paul Simon, have a knack of saying deep things in the simplest of words. “The Boxer” is a song written by Paul Simon and performed by the duo. Here are the lines I want to talk about.:

Quote:
All lies and jests
Still a man hears what he wants to hear
And disregards the rest
-- Paul Simon, “The Boxer”

Hearing what you want to hear is one of the most important factors which makes two value investors disagree on a stock pick.

Selective hearing is not a new invention. Following are the lines from the New Testament:

Quote:
For a time is coming when people will no longer listen to sound and wholesome teaching. They will follow their own desires and will look for teachers who will tell them whatever their itching ears want to hear.
- Timothy 4:3

This simple observation has some major repercussions, financially and socially.

• We do not like hearing truth which is uncomfortable to us. If an event occurs that does not fit our mental models developed over our lifetime, then we consider the discomforting evidence as an anomaly and only make minor correction or no corrections at all.
• We actively look for evidence which agrees with our world view and succumb to the “confirmation bias.” The sane thing to do would be to look for disconfirming evidence. Disconfirming evidence is going to prove your view incorrect. A confirming evidence increases your confidence in a possibly wrong idea.
• We love to hear flattery. We like people who make us feel good and tell us that we are smart, beautiful/handsome, funny and a great human being. If the flattery is not too obsequious then people believe quite easily, even when there are glaring inconsistencies. This is the case of “disregarding the rest.”
• We like a good story. A good and coherent story makes us feel comfortable. So what if it is untrue? Being untrue is a “small detail” which can be ignored. Succumbing to a narrative sets up for “narrative fallacy,” weaving a story out of a sequence of facts. We look at a set of facts and invent a story which “explains” them better. We think that we have a better understanding of the situation. For example, we now “know” that the intelligence agencies made grave mistakes leading up to the 9/11 attacks. There were many journalists reporting on facts which were clearly pointing towards a major attack, even to a non-expert. There was report of a terrorist who actually gave the entire plot to someone in the agency but was not taken seriously. Under these “facts” (and several others) a narrative of willful ignorance emerges which gives comfort to the 9/11 conspiracy clique. But do you know how many terrorists/people contact the CIA with “major revelations?” How does the agency know of which leads to follow? It is not at all clear and mistakes are bound to happen. It does not mean that there was a detectable common narrative running along these facts when they were happening. It only looks clear in retrospect because we ignore all the other possibilities which did not materialize.
• The problem of “silent evidence.” In hindsight, we find everything much easier to explain. We cherry pick the data and journalists do “investigative work” to “verify” the reasons which explain an event. Pick your favorite event, which was surprising when it happened (e.g. inflation during the Weimar Republic in Germany). A few weeks/months/year later, there are people everywhere saying that they “knew” it all along. The reasons/facts were there for everyone to see. They point out the “reasons” as to why the event occurred and many people congratulate these “geniuses” and feel quite stupid for missing such an obvious cause-and-effect scenario. But think of all the other geniuses who predicted something entirely different. If the whole of Africa disappears in the ocean, I am pretty sure there will be people claiming that they “saw” it. And I am sure that they can back it up too. There are always people who believe in crazy things. It does not mean that we have any way to know which one to listen to.

I am sure I can come up with a lot of other situations where we are guilty of this fallacy. But I want to talk about the investment process and why two people differ when they view the same data.

One of my stocks is killing me, Hewlett Packard (HPQ), so I am going to take it as an example. I strongly urge you to read on, even if you are not interested in HP stock. Because this is not really an article on HP, but on us.

The fact is that HP was trading at $18; then they said that the “turnaround” would take a longer time than expected. The stock crashed to $15 and was trading around that point when the fourth quarter results were out. The results in themselves were not bad at all. If we add back the write-off of $8.8 billion, then HP made $1.20 a share for the quarter. In fairness, HP generally always has a write off of around $800 million and taking that into account, we still have an earning of $0.80 a share. I agree that this is rather simplistic view of the situation and at this point there is so much negativity surrounding the stock that any discussion seems out of place.

The kicker was the claim that it overpaid for the Autonomy acquisition because Autonomy management had knowingly duped HP by keeping false accounts and has committed serious accounting shenanigans. Although it was obvious to anyone that it overpaid for Autonomy, apparently HP management failed to see it until now.

A major problem during a situation like this, i.e. when the market is panicking and HP lost $3.8 billion of market cap in one day (dropped from $13.35 to $11.35), is to distinguish “fact” from “fiction.” Let me explain.

Even if it is obvious to many of you that it is a folly to hold HP, I have in some sense convinced myself that it is not. I was a buyer around $30. I already knew that Autonomy was a waste of money. I also knew that PCs is a no-growth business.

The only new information I have is that some of the enterprise customers are leaving HP, an alarming development, I know. But this has not yet reached alarming levels. There was significant management upheaval at HP, and we need to give it some time to stabilize the operations. It is a good sign that Meg Whitman has lasted a year.

But then again, this might be a rationalization of what “I want to hear.” I want to hear that my investment thesis has not soured. So I rationalize by concentrating on “facts” that support my thesis, and I conveniently ignore the “facts” that do not, i.e. customers leaving, declining sales, serious accounting fraud, etc.

It would be very, very difficult to abandon ship in this case. The facts and the fiction are so muddled up that I am unable to distinguish between them. The only way is to let the investment run its course. Either the company recovers or goes bankrupt. We will know in a few years, I hope. For the opportunity cost, well, I have money lying around to invest, if need arises.

If you realize you have made a mistake, why not take a loss and sell and invest in stock that you like. Are u worried u might be selling at bottom? Or are there no investments that fancy you?

CD,

Thanks for the article. I'd like to challenge much of what you wrote, as it seems to me to be either non-representative or misguided.

1. "Hearing what you want to hear is one of the most important factors which makes two value investors disagree on a stock pick."
Maybe the know-nothing investor is doing this, but it's really a contradiction in terms. Any investor 'hearing what (s)he wants to hear' is not worthy of the label value investor. If Buffett and I were to disagree on a stock pick, I can assure you it would not be because we have selective hearing. It would obviously be because he is the best investor on the planet and as such has infinitely superior investing abilities and insights. Many of the best value investors talk about how they try to kill investment ideas before they consider buying. In other words, they're actively looking for flaws or unobvious risk, which is the opposite of not wanting to hear. Berkowitz does this in an extreme way by bringing in experts in a field to be devils' advocates on his investing ideas.

2. Following this, I simply don't agree with your extrapolations to life - though flattery is a challenge to anyone's ego.

3. Moving on to HPQ, you wrote:
"I was a buyer around $30. I already knew that Autonomy was a waste of money. I also knew that PCs is a no-growth business."
A not unreasonable conclusion from this might be that your analysis was qualitative and superficial. Did you (attempt to) quantitate these issues? These happen to be two of the issues described by Jim Chanos in his assessment of HPQ and decision to go short. I've got to admit they're likely to be very difficult to assess. But if that was the case, then HPQ was arguably outside your circle of competence. I looked at HPQ after Klarman bought just at the time Chanos announced he was short. I put it on what Munger would call the "too difficult pile".

4. Also regarding HPQ, Ben Graham's advice came to mind:
"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."
Despite Chanos being short and Klarman baling out, and with the stock now around $12, you can still be right to hang in - but only if you believe you have superior analysis. Your admission:"The facts and the fiction are so muddled up that I am unable to distinguish between them"
might suggest you do not.

Thanks for the stimulation - and apologies for the long post.

Disclosure: long Simon and Garfunkel

@Superguru: HP is priced for disaster. It has $122 billion in sales and $26 billion in market cap. If sales halve and it can achieve a net margin of 4.36% then it will still sport a P/E of 10. If HP survives as a shell of its former self, it will still be cheap at current prices. I am not selling at these prices.

@Vgm: Ok, I have been quite hasty with my conclusions. Let me offer my own viewpoint.

1. Selective hearing is not the correct phrase. I take that back. But two people look at the same data and reach different conclusions. An example can be taken from your comment. Jim Chanos and Seth Klarman are both value investors (in the original sense of the word) and while Chanos was shorting the stock, Klarman was buying it. One can dig out many cases like this. Neil Woodford was selling Tesco while Buffett was buying. Sometimes two value investors do find themselves at different end of a trade. Both of them look at the same data and reach oposite conclusions. Who is correct ? Hard to say.

Obviously, this destroys my claim and the relation to the song ... but meh :)

2. Ok, this one I totally disagree with. People do look for confirming evidence and try to avoid discomforting truth. I am not talking about value investors here but people in general.

3. At $30 it was a mistake. There was not sufficient margin of safety. It might also have been outside my circle of competence, but when I bought it ... I did not know what a circle of competence is. It probably is still not entirely inside my circle of competence. But I don't think I will have 100% confidence in any of my investments and that is fine. My reasons for staying long at these prices is summarized in the previous comment.

4. Right again. Looking at the big picture (sales vs market cap) I am comfortable enough with my analysis of the cheapness that I plan to stay long.

Thank you, those were some excellent comments to defend against. I hope I corrected myself a bit.

" But I don't think I will have 100% confidence in any of my investments."

I'd say one should make an investment only when it is a cinch i.e. a no brainer. Its much more difficult to be patient than to swing at a pitch.

@Cdubey: Keep doing the math. I stepped in at $25,50 with a calculated value of $34. Now my calculation of the value using the same variables (Graham number using tangible + intangible book value) is $26. We've lost money, but hopefully not as much as Mr. Market feels. Not time to sell.

Hi Chandan, thanks for your article, I found it interesting and useful. One rule I try to follow with my investments that go wrong is to ask myself the question. Would I buy this stock knowing what I know now? If the answer is NO, then I should sell the stock. If the answer is YES, then I should hold.

@Darps: You are exactly right. A no-brainer investment is the one to go.

But even with a no-brainer investment you cannot be 100% sure. Self doubt and questioning your thesis is an integral part of investing. You can make sure that the downside is small, but there is no such thing as 100% confidence. Things can happen which are outside your model and can impair the value of the investment. This is why you need to diversify. Otherwise, it will be best to hold just one company which you are most sure about.

@Graemew: This is exactly why I am not selling. I will rather buy HP than sell it at these prices.

I am not unknown to taking losses. I took a SFR 5000 loss, a 10% of my total portfolio at that time, on Credit Suisse in Mar 2012 and you can read about it here (Righting the ship). But with Credit Suisse I had no idea about the exposure or the value of the company. It was completely outside my circle of competence. With HP it is a different story. So, I am happy to wait.