The following article is the first part of a series designed to help investors develop their own investment process and increase the efficiency of dealing with the daily deluge of investment ideas that are now available to investors, thanks to the Internet.
A long time ago when I was trying to learn how to draw and paint (note: unless childlike stick figures become immensely popular I failed, which is why I became a photographer), I read a book called ""Drawing on the Right Side of the Brain by Betty Edwards. The idea of the book was to help a person tap on the strengths of the right side of the brain and “deepen your artistic perception” when engaging in creative endeavors. Athletes and musicians often talk about “being in the zone” and from personal experience as an investment analyst, a drummer and a professional sports photographer, I can tell you that you can put your brain in either a “right brain” or “left brain” thinking mode.
One of the first exercises in Edward’s book is to look at a picture and draw it. More than likely it will look “okay” but the perspective and other things may not look just right. The author then tells the reader to turn the picture upside down and draw it again. You would be amazed at how much closer to the original the second drawing looks than the first attempt. Why is that? Edwards explains that since the brain doesn’t recognize the upside down drawing as an object, the brain switches to the right side and allows the artist to “see it” more in the abstract and not a preconceived recognizable image, which makes it easier to “draw” the lines more accurately. Since successful analysts incorporate the ability to think in non-linear, non-analytic ways, being able to tap into those aspects of the right side of the brain is very important. This idea can be thought of as “inversion.”
“Man Muss Immer Umkehren” - Carl Gustav Jacob Jacobi
The idea of using inversion to solve problems is not a new one. Carl Jacobi was a German mathematician who lived in the early to mid-1800s. He believed that finding the solution to many difficult mathematical problems could be achieved if the problem was expressed in the inverse. For those who are curious, here is an example of one of those problems. Of course, most investors are more familiar with the English translation of the quote above — “invert, always invert” — which was made famous by Charlie Munger.
It is no coincidence that these words of wisdom are often cited as “pure genius” and is an extremely valuable insight to being a successful investor. Munger suggests that investors use the same technique for breaking free from the left side of the brain thinking and into the more creative right side of the brain that Betty Edwards does, which is to turn the “image upside down.”
This type of thinking also helps investors, to borrow from Templeton Fund’s advertising campaign, “See today what others see eventually.” This idea is also similar to the concept of “second level thinking” discussed in Howard Marks’ book, "The Most Important Thing." (See our review of the book here and a comment on second level thinking.)
When the idea comes from our own thought process, it is easier to put our brain into “right side mode” and focus our initial analysis in a more productive way. For example, if we are looking at potential investment ideas from a list of low price to book companies, then our focus most likely will start on the balance sheet. If we are starting with a list of low enterprise value to revenue companies, however, then we may start with historical margins or revenue growth rates. From the beginning, we have a process and are mentally focused on what we are trying to analyze and why. We also generally know what we should be looking for in terms of risks.
However, when the idea is presented to us from an outside source (newsletter, investor conference, blog, etc.), we are more likely just to “see” it as it is, rather than in a more objective, “right-brained” way. It is much more difficult to have a conviction in an idea derived from an outside source as strong as one an investor analyzes from start to finish, no matter how thorough the original source’s research was. Each person’s analytical process is different, so the conclusions made by one person are not always going to be the same as another’s, even with the exact same information.
There are numerous websites and bloggers that aggregate and distribute investment presentations from most of the value investor conferences and from respected bloggers and authors. Activist shareholder filings (13Ds) and “guru” portfolios are carefully monitored, and there are even mutual funds and ETFs that invest exclusively in these ideas. Judging by the media frenzy and stock price movements that surround the disclosure of an idea at one of these conferences, we feel that too many investors (professional and non-professional alike) are just “buying or selling the news” and are taking the investment recommendation at face value. We think increased access to investment ideas and information from the Internet has actually weakened the quality of the analytical process used in making investment decisions. This may seem counter-intuitive, but we believe it to be true. We think that putting your thinking into “right-brain” mode will improve your analytical process and help separate great ideas from good or even bad ideas.
So how would someone put our brain into "right-side" mode when we see an idea from another source? The first thing you can do is to develop the opposing view and try and "kill" the idea. By doing this you are "inverting" the idea from the start. For example, if an investment thesis is premised on investors over estimating a liquidity risk event (in other words overly discounting the valuation of the company due to a default risk, which happened to lots of companies in 2008 to 2009), the analyst should try and see what would actually cause a covenant violation or what the maturity dates are of the debt that could be trigger points and the company's option at that point. This puts the analyst in a mode to prove to himself that this is not a risk and not just to accept the opinion of another.
After all, apparently there are a large number of investors that do believe it is a real risk, otherwise the stock may not be priced where it is. Changes in margin assumptions and revenue growth rates are also common themes in investment ideas. Once again, the analyst should look at historical rates for the company and try to understand the dynamics of why margins or revenue growth are different from those and make some of his own assumptions.
Question every part of the investment thesis of the idea that has come to you from an outside source and try to come up with a few more. Reading the risk section and the footnotes of SEC filings is another great way to get into the right-brain mode. It takes you away from the bias of the analyst and puts things into analytical terms. Ironically, this brings you temporally out of right-brain mode so you can have a clean slate when you start thinking about the investment thesis. You are outside looking in and have separated your initial connection with the idea.
By approaching the investment idea from this inverted view, an investor has a better understanding of the merits and strengths and omissions of the original idea. It also allows the investor to rearrange the idea into his set of priorities for investing. For example, perhaps the original idea put more emphasis on revenue growth and less on free cash flow. But you may place a higher emphasis on the latter. This will help the analyst become even more comfortable with the idea because it is now structured more along the lines of their thinking process and it is easier to own the idea now.
In a later post I am going to talk about why we passed on a stock idea we saw at an investor conference. The idea is sound and will probably work out, but we just didn't feel a high enough conviction with the idea. And this is in spite of the fact that we were able to eliminate our initial biggest risk to the idea!!!! But using right-brain thinking we became less comfortable with what most investors take for granted as a given in the investment thesis. Not they we are right and the others are wrong, we just are choosing to take this pitch for now. Perhaps we will be caught looking and miss a great opportunity. But it is a long season.