At the USC Law Commencement Speech in 2007, Charlie Munger praised Charles Darwin as a model of rational, objective thought, particularly his habit of trying to consciously overcome first-conclusion bias. This is one of the many forms of over-confidence bias that can be damaging to your wealth.
Munger stated that Darwin, “tried to disconfirm his ideas as soon as he got’em. He quickly put down in his notebook anything that disconfirmed a much-loved idea. He especially sought out such things.”
Following Darwin and Munger, we too should seek out that which disconfirms our own investment theses. Put simply, you should try to kill our own ideas. It is far too easy to fall in love with a stock and then let your own rose-colored glasses glibly filter away anything negative about the business. Of course, this is delusional: the market does not care if you like a stock and reality will ultimately have its way.
This type of disconfirming thinking was on full display at the 4th Annual Pershing Square Challenge, in which Columbia Business School students compete for a $100,000 prize in an American-Idol like stock picking contest.
One of the finalist teams pitched Aeropostale (ARO). They argued that Aeropostale is a best-in-class retailer which earns consistently high returns on equity. They highlighted the company’s multi-year same-store sales growth, and growth opportunities coming from international expansion, e-commerce sales, and P.S. from Aeropostale, a new concept which targets pre-teens. Also, they liked Aeropostale’s valuation – the stock was then in the mid 20’s – because they thought it gave no credit for Aeropostale’s growth prospects and that the company’s unlevered balance sheet provided an attractive target to leveraged buyout firms.
The Aeropostale team received a respectful grilling from the judges, which comprised a cadre of value-oriented hedge fund heavyweights led by Bill Ackman. The hedge fund judges did not appear overly taken with the team’s thesis. The concerns the judges raised, which were summarized at the end of the presentation by Ackman, provides a text-book example of the types of things you should be looking for when you seek disconfirming evidence. Of course, it goes without saying that raising a concern is not tantamount to proving that it will come to pass, but the process of raising objections and dealing with them is critically important in reducing mistakes and generating market-beating performance. If you do this religiously, you will have a leg up on all your competitors and counter-parties who do not.
Returning to the Aeropostale pitch, here is Ackman’s summary of the disconfirming concerns.
1. Aeropostale does not do anything proprietary; in other words, they do not have a moat. They piggyback off the intellectual property of other teen retailers such as Abercrombie & Fitch.
2. Aeropostale’s thinner margins vis-à-vis its competitors makes it more vulnerable to higher commodity prices.
3. The growth opportunity is overstated. Aeropostale has already saturated the United States. In fact, Ackman questioned whether the total number of U.S. stores already exceeds the number of quality U.S. malls.
4. There is upward rent pressure and Aeropostale is susceptible to negative leverage if margins compress, given its fixed costs.
5. The market is used to strong same-store sales growth and could re-adjust Aeropostale’s multiple downward if the business generated negative numbers. [Note: the stock subsequently sold off to under $10 a share on poor same-store sales, among other factors, and has since rebounded to $16 per share.]
The lesson here is to look for disconfirming evidence, write it down (given the brain’s seemingly unlimited capacity to rationalize away this type of information), and take the time to give it serious thought before going forward.
#28: Insist on “mistakability"
One important element of the scientific method is having a properly constructed hypothesis. One of the essential characteristics of a good hypothesis is that it can be refuted or contradicted by an observation or physical experiment. Scientists call this characteristic falsifiability.
Likewise, one indispensible component of a market-beating investment process is being able to know if you made a mistake. Taking a page from science, we could call this characteristic “mistakability”. A good investing thesis is one that at some point in the future – as result of study and observation – you will be able to know if you were mistaken about, or not.
Speculating per se does not possess this quality. It often relies on nothing more that the notion that something is going up or down and that it will continue to do so. If it does not work out, it is insufficient – at least by the standard I am suggesting – to assert that you made a mistake because it stopped doing so. This is circular logic.
True mistakability is a substantive, positive, assertion grounded in logic and fact. “I think Microsoft’s current software royalties will continue to grow at five to seven percent over the next ten years and that its core software franchise is well protected by a strong moat grounded in high-switching costs and network effects.
If you do not have a clear, written investment thesis for each holding, each of which exhibits mistakability, you may be fooling yourself. If you manage money for others and an investment does not work out, you owe it to your investors to be able to provide a clear explanation of why you invested and what went wrong.
Market-beating investing is predicated on clear, rational thinking and avoiding dumb mistakes. Insisting that your investment theses possess mistakability is essential.
#29: Double down on process
One of human beings’ quirks is that we are attracted to action. We want something to always be going on. My kids will come to me and say, “I’m bored.” It is not a state they like, and they want me to fix it by conjuring up some exciting activity on the spot.
Thinking about your investing process is not all that attractive to most investors. It seems boring. “Forget process. Just point me in the direction of the next ten-bagger and I’ll be happy.”
Regardless of how we see the world, truth has a way of imposing itself. And the truth is that process is boring, but it is where you can arguably make the most progress as an investor, if you relentlessly focus on it. Over time you will get better, and your results will improve.
Buffett has rightly said that what an investor needs to be successful is a rational framework and the right temperament. He’s correct, of course. But too many stop there and spend, perhaps, too much time thinking about their investment philosophy and not enough time on their process.
Here are some questions that can help you improve your process:
1. How do you search for new ideas?
2. Is your search strategy robust, i.e. does it reasonably insure that you will not miss attractive investments within your circle of competence?
3. How often do you run your screens? Are you consistent?
4. Do you have preliminary filters in place – required hurdle rate, risk profile, complexity, un-knowability, etc. – to quickly weed out ideas and not waste precious research time?
5. When you do find an idea, do you have a well-defined research process or checklist that you go through, without exceptions?
6. Have you carefully defined your valuation methodology? How could you improve it? Do you have a required hurdle rate, and is it appropriate?
7. Do you have investment checklists to help determine if a business is good and if management is a worthy steward of your capital?
8. Do you have a cognitive bias checklist in place to minimize the risk of biased or faulty thinking when evaluating an investment?
9. Do you have a watchlist? Is it up to date? Is it a hodgepodge, or does it contain actionable stocks with pre-determined buy prices?
10. Do you write down your investment thesis, prior to pulling the trigger on a new investment?
11. How do you size a new positions? How many stocks do you hold? Are you a focused investor (Glenn Greenberg) or widely diversified (Walter Schloss)? Why?
12. Do you scale into new positions? Do you buy more when a stock goes down? Do you do this haphazardly or have you thought it through?
13. Do you hold cash and, if so, how much? How did you determine the amount? Does your hurdle rate go up as you cash holdings go down, i.e. do you become increasingly selective as your cash goes, for example, under 20%?
14. How do you monitor your existing holdings? How are you organized to stay on top of your investments? How could you improve?
15. Do you listen to conference calls and read the Q’s? Do you look for disconfirming evidence that challenges your thesis?
16. Have you defined your sell criteria? If you are a long-term investor, is there an over-valuation level at which you would sell? Do you figure it out ahead of time and mark it down?
17. Do you trade around positions – making partial sells and buys as your stocks become over or undersold? Why or why not?
18. Do you review your past mistakes? Do you record your lessons in a form that you can review and learn from?
19. Do you have a time when you regularly review your investment process – all of the above – and make a plan to improve it?
These questions are not exhaustive, nor are they meant to be. They are, however, more than sufficient to get you thinking about your own process and how to make it better. This is the path to beating the market.