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The Pareto Principle and Investing

April 12, 2013 | About:
The Pareto Principle states that 80% of the results, outputs or rewards, are generated from only 20% of the causing inputs or efforts.

The implications for investing:

1. 20% of our best stocks will probably generate 80% of our overall profit.

2. 20% of the time we spent doing research usually generates 80% of the most useful information.

3. 80% of the time we spent doing research is likely not very productive.

The above implications can be very discouraging for investors who have never thought about applying the Pareto Principle to their investment research. In fact, I wrote this article because I was truly disappointed and bothered by the feeling that most of my time spent doing fundamental analysis is not targeting the most important things. Why? Because I often forget to write out the most important thing first before I even start my research. This article is trying to address implication 2 and 3 above.

My investment research routine is:

1. Research company background, read the most recent three to five 10-Ks and 10-Qs of the company and those of its competitors to answer every question on my checklist.

2. Gather 10 years of financial statements and build the valuation model.

3. Calculate intrinsic value and margin of safety.

I usually spend about 90% of the time performing step 1 and step 2 above. The intrinsic value and margin of safety calculations are the most important things, but they usually takes about 10% of my time. Well, you can argue that step 1 and step 2 above are necessary as they build the foundation for step 3, but step 1 and step 2 frequently incorporate a lot of assumptions. And each one of them may impact the ultimate result in step 3. Garbage in and garbage out. The majority of the information I gather in step 1 and step 2 ends up being inconsequential. Therefore, it's not the quantity of time you spend that will ultimately determine the quality of your research, it's the quantity of time you spend addressing the most important things that really matter.

Here is a most recent example. I have been digging into the for-profit education sector and have spent a massive amount of time just to gather all the financial data and incorporate it into the valuation model. I've also read the 10-Ks for Strayer Education, Apollo, Capella and Career Education. However, just like someone driving around in a strange city without navigation, I wandered around for a while, lost and still not getting to the point. I read all the business description, all the risk factors and the regulatory environment but still have not put all the piecemeal information together in a meaningful way because I have already spent so much time, and I feel justified to delay the ultimate intrinsic value calculation.

To quote Michael Bauboussin: "Most people do not find it natural to match ideas from their mental database to tricky situations in the real world. Our brains are not wired for the process of moving from preparation to recognition. Indeed, typical decision makers allocate only 25% of their time to thinking about the problem properly and learning from experience. Most spend their time gathering information, which feels like progress and appears diligent to superiors. But information without context is falsely empowering. if you do not properly understand the challenges involved in your decision, this data will offer nothing to improve the accuracy of the decision and actually may create misplaced confidence."

[/i]He is exactly right. In doing fundamental research, we often gather information for the sake of gathering information, which feels like progress and creates misplaced confidence because we tell ourselves that we spent a lot of time doing research and therefore, we should have confidence in our thesis. This fallacy is very dangerous, especially in the world of investing, yet so many of us have been ignorant of it. The best way to cope with this is to begin our investment process by asking ourselves, "What are the most important things?"

With regards to the for-profit education sector, the most important things are:

I. How likely is it that an institution is not in compliance with regulation and can the institution go out of business if not in compliance? Specifically, what is the institution's compliance status with regards to:

Cohort default rateThe 90/10 ruleIncentive compensationGainful employment At least 35% of students are in satisfactory repayment status with respect to their federal student loans three to four years after entering repayments. If the annual loan payment of a typical graduate of the program for all debt incurred by the graduate for the program does not exceed 30% of the average or median discretionary income in the third or fourth year after graduation; orIf the annual loan payment of a typical graduate of the program for all debt incurred by the graduate for the program does not exceed 12% of the average or median annual earnings in the third or fourth year after graduation; II. Is the headwind that the for-profit education sector is facing a structural issue or cyclical issue?

III. If the headwind is a cyclical issue, what will the enrollment level be once things return to normal?

IV. What strategies are being executed to address both the current headwind and future development?

V. Given I-IV, what is the intrinsic value of the business?

I am absolutely not indicating we should abandon hardcore fundamental analysis. Diligent fundamental analysis is what defines value investors. What I am suggesting is that before we start our research, we should take the time to define our focus points in our research. Once we lay out the most important things, we can direct our research to address them first.

Once we've answered all these vital questions, we can dive into other things. Warren Buffett once said: [i]The chain of habit is too light to be felt until it's too heavy to be broken.
The habits we cultivated as teenagers inevitably affect how we behave as adults. In investing, in order to not lose money and generate superior return, we have to be cognizant of the habits we cultivated when we were young that could inherently lower the quality of our research and hence, the potential return of our investment. It takes time and can be against human nature to step back and question ourselves, but that's how we become better over time.

By the way, here are two much better articles on similar topic from Geoff Gannon.

http://www.gurufocus.com/news/212478/5-things-i-look-for-in-a-stock

http://www.gurufocus.com/news/197914/whats-your-research-process

As always, I welcome all constructive criticism.

About the author:


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Comments

Cornelius Chan
Cornelius Chan - 1 year ago
I really like your 3 implications for investing taking from Pareto's principle. I am sure the 20% effort returns 80% results is why most of us will only achieve good results later on in life. Experience is the hardest teacher. I have spent 70% of my free time learning how to invest in stocks since 2005. What have I achieved in that time? I went from an absolutely naive and greenhorn baby to a teenager of investing. Now I am concentrating on learning from the New Buffettology book by Mary Buffett. This book is going to bring me up by the order of magnitude into a higher state of investing principle and plan. Thanks goes to Bel-Air for informing me of Buffettology. I have learned how ignorant I was without it. But then, as a professor once told the class: the prerequisite for being here is ignorance.
batbeer2
Batbeer2 premium member - 1 year ago
Thanks for an article worth reading!

BUT....

I think your focus points are not an improvement over Phil Fisher's 15 point list.

One reason I prefer Fisher's list is because the very first question forces you to look at the competition and potential market opportunity.

Specifically for the for-profits, it's interesting to find out what their market share is, who they are competing with and how those competitors are doing.
Cornelius Chan
Cornelius Chan - 1 year ago
"I think your focus points are not an improvement over Phil Fisher's 15 point list."

Thanks for the link. I was unaware of that list.

About the list... First, it is complicated, second it is too long and third it is impractical for your typical at home DIY'er. More than half of the list are qualitative factors that are too time consuming to find out. I can run a screener and start my investigative process that way and then move on to reading individual annual reports. Am I going to try and solve point 4 "Does the company have an above-average sales organization?" by seeing if revenues have been growing steadily over the past 10 years? You bet I will. That is the job of the sales force... to grow revenue. It is the job of management to increase profit margin and net income.

I could go on, but let me summarize by saying: Phil Fisher's 15 point may be good for full time investment professionals, but for your average at home DIY'er, forget it. Take the best points from the list and boil them down into your own system of investment. Never forget the KISS formula.

Too much work to do all this... also never forget to have fun and put the investing homework aside. One needs a break every once in a while. A simpler list will allow you to bang through your homework faster and make a buy-list-or-too-hard-pile decision faster.

batbeer2
Batbeer2 premium member - 1 year ago
>> Am I going to try and solve point 4 "Does the company have an above-average sales organization?" by seeing if revenues have been growing steadily over the past 10 years? You bet I will.

It seems to me you are trying to find a maximum number of stocks to trade while spending a minimum amount of time on research. My goal is the precise opposite.

In Pareto terms... If 20% of my ideas are going to generate 80% of my returns, I'm going to find out which 20% will.

Ironically, all I will accomplish is compile a portfolio of stocks of which 20% will generate 80% of returns.

BUT

The results will be better.

Rinse, repeat.

That's Pareto.

>> Too much work to do all this... also never forget to have fun and put the investing homework aside.

To some, the homework is the fun. Make no mistake about it, that is who you are up against.
Cornelius Chan
Cornelius Chan - 1 year ago
Just got back from some fun... good to recreate. Gives one fresh energy for the endless work of investing homework. Since I do have a passion for this thing, it is less work than fun. However, even to the most passionate, there will always be an element of work... and I am far from the most. But working on it.

"It seems to me you are trying to find a maximum number of stocks to trade while spending a minimum amount of time on research. My goal is the precise opposite.

In Pareto terms... If 20% of my ideas are going to generate 80% of my returns, I'm going to find out which 20% will.

Ironically, all I will accomplish is compile a portfolio of stocks of which 20% will generate 80% of returns.
"

There are hundreds of stocks in my general watchlist (remember Buffett "start with the A's?"). This is because you never know when a blue chip stock (of which there are thousands) will have a temporary crisis, creating an opportunity to make short-to-medium-term money. Case in point: Herbalife. A first class stock caught in a temporary (non) crisis. Have I done deep homework on all these stocks? No. Do I have a simple criteria that prequalifies these stocks as investment grade? Yes. Was this first part a lot of work? Not more than setting up and running a good screener. I think you get the point.

From what I have learned works in the stock market, a portion of my stocks are buy'n'hold and the rest are medium or short term opportunistic investments. I never use the word trade for what I do because the stocks I pick are always investment grade - meaning they are good quality for the long term fundamentals stocks, but not necessarily for the holding time. Do you understand this?

You make a good point about finding those 20% that will generate the bulk of returns. Isn't that what we are all doing? ;-) Whether in reality or fantasy is another matter... LOL! But I am sure in your particular case, you are doing a good job :-) Me? The jury is still out LOL!!

"Make no mistake about it, that is who you are up against."

If I were trading I might be worried. Since I'm investing it's no sweat man.
Cornelius Chan
Cornelius Chan - 1 year ago
Clarification on the term trade: to me, "trade" is no more and no less the process of physically buying or selling a stock. So trading to me is a meaningless term in the world of stock market investing.

Speculating vs. investing on the other hand... a long story. Since the stocks I pick are always investment grade rather than speculative issues, I am a fair ways ahead of the crowd.

Some interesting crowd quotes:

1. Psychology The market is nothing more than crowd psychology in motion, moving from

optimism to pessimism, and pessimism to optimism without knowing what the hell is all about.

2. Herd Instinct The crowd is as easily frightened as a flock of sheep and is credulous to the point

of stupidity.

3. Rule Buy cheap and sell dear is the rule of the game. The public as a whole, exactly reverses the rule.

4. Trend The public is right during the trend, but wrong at both ends of the trend.

5. Feeling People feel bad to stand alone from the crowd because they know too little about themselves.

6. Follow In the stock market, as elsewhere, people love to follow a leader.

7. Reason The crowd does not reason, it only thinks it reasons.

8. Illogical Thinking It is easier for the crowd to believe a stock is cheap when it is really dear than

to believe it is cheap when it is really cheap.

9. Behavior The crowd always loses because it is always wrong. It is wrong because it

behaves normally.

10. Mythology According to investment mythology, the crowd is always wrong and the crowd

always loses.

No one after reading this will want to be part of a crowd, but it is really comfy to be part of the crowd than not to be comfy.

20punches
20punches - 1 year ago
C.W.R: Thanks for your comments. I've always enjoyed reading your comments (not just on my article). Fisher's 15 points are time-proofed and are definitely worth the time. Like you mentioned, for part time value investors like us, it may not be practical to go through all those 15 points. It is a much better checklist though but also harder to apply. It's difficult to compete against the best and brightest in this field but I do think over the long term, as long as we are persistent, patient, tenacious and diligent, we should achieve at least satisfactory returns.
20punches
20punches - 1 year ago
Batbeer2- Thanks for the comments. I am certainly aware that my list is nowhere close to Fisher's 15 points checklist. I'd really appreciate if you can share your experience applying Fisher's scuttlebutt approach as a professional or non-professional investor.
batbeer2
Batbeer2 premium member - 1 year ago
Hi Jianing7978,

>> I'd really appreciate if you can share your experience applying Fisher's scuttlebutt approach as a professional or non-professional investor.

I like to think this discussion of Quadracci was inspired by Fisher's questionnaire. I don't use Fisher's scuttlebutt approach to find the answers though. I read a bit and think a lot.
mungerman
Mungerman - 1 year ago
As I read your article, I couldn't help but think about Buffett's concept relating to circle of competence. I think it takes successful investors sometimes many years to understand an industry and the companies within it, so accumulated knowledge is gained over long periods of time. Charlie Munger has said "the game of investing is one of making better predictions about the future than other people. Limit your tries to areas of competence. If you try to predict the the future of everything, you attempt too much. You're going to fail through lack of specialization."
AlbertaSunwapta
AlbertaSunwapta - 1 year ago
^ and if you study high tech industries, prepare to find yourself attaining great knowledge of things like fax machine and pager production just as the world decides such knowledge is worth-less.

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