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Handicapping Like Warren Buffett

April 24, 2014 | About:
Grahamites

Grahamites

112 followers
Here is how a typical investment write-up usually looks like:

  1. Business description…….
  2. History of business…….
  3. Segment Information…….
  4. Industry information……
  5. Competition…….
  6. Management Information……
  7. Recent development…….
  8. Financial information…….
  9. Ratio analysis…….
  10. Risk factors…….
  11. Bull and bear argument…….
  12. Valuation and margin of safety…….
  13. Conclusion……
Formats and contents may vary among investors but I think it’s safe to say that the above structure is fairly common. In fact, I myself have been using a similar structure just until recently. It has almost become my routine in any company specific investment analysis.

Is there anything wrong with this routine? Aren’t you supposed to know as much as possible about a company you are interested in investing in?

This may sound provocative but my answer to both of these questions are “no.”

Before I proceed, a clarification seems necessary. There are huge differences between studying a company and making investment decisions about a company. The biggest difference is the former is knowledge accumulation while the latter is what we call “in practice.” I think when you study a business as part of your knowledge accumulation process, the structure listed above will serve you well. However, for an investment analysis write-up, I think we may need to consider Warren Buffett (Trades, Portfolio)’s Horse Handicapping approach in order to get the most out of the research process.

To appreciate Buffett’s approach, it might be useful to use the inversion principle and discuss the disadvantages of the common approach. The problem with most investment analysis, in my opinion, is that so much time and effort is spent on finding information that may not even be relevant or material to the thesis. This may sound provocative but I think there is a fair amount of truth in it. For example, I was reading a write up on Apple on a widely known investment website and to respect the author, I will not disclose the title of the article here. The author discussed in great details about the most recent quarterly revenue, management guidance, iPhone and iPad’s superiority, Apple’s strong balance sheet and etc. In the end, the author showed his model and concluded that Apple is cheap at this price.

The analysis was very detailed and I can tell the author spent a lot of time on his report. However, it didn’t convince me to buy Apple. I’ve seen similar write-ups on Weight Watchers International, IBM, Johnson and Johnson. You name it.

What’s missing in these write-ups? You may disagree but I think Mr. Buffett would agree that they don’t address something extremely important - i.e the one or two factors that make the investment idea succeed or fail. This is the essence of Buffett’s Horse Handicapping approach. You have to nail down the most important factors that can make your horse win or lose, otherwise your odds are not going to look good. In Apple’s case, the most important factors are:

  1. How likely will the balancing feedback loop dominate the reinforcing feedback loop for Apple’s most lucrative products? In other words, what is the likelihood that Apple will maintain or lose its dominance in the smartphone and tablets market and what data should we track to support our hypothesis?
  2. What are the odds that Apple can come out with another revolutionary product that can reach the market size of iPhone and iPad?
The answers to those two questions determine the multiples you can apply to Apple’s common stock. Unfortunately, there are no easy answers and your answers cannot be based on intuition, which is the shortcut our brain is wired to take. They have to be based on sound analysis backed up by statistics. By focusing on those two most important questions, you will exempt yourself from spending 80% of the time on inconsequential information, such as last quarter’s revenue and earnings. You may argue there are more than two critical factors and I certainly think you can list up 5 factors. If you have too many “most important factors”, they may not be important after all.

I have revamped my investment research process by incorporating Buffett’s handicapping technique and I have to say, it has completely changed the way I approach an investment idea. You really have to experiment it by yourself to see the power of this approach. Obviously the trick is identifying the right factors. And only knowledge and experiences can do the trick.


Rating: 4.6/5 (21 votes)

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Comments

jtdaniel
Jtdaniel premium member - 3 months ago

Hi Grahamites,

Great article - the voters are pretty unanimous on that! I have been wrestling with your two factors for a few days and cannot come up an with objective answer to either question. Proper allocation of the cash horde is a huge consideration (advertising is needed for Factor #1 and R&D for Factor #2). Will Apple continue to emphasize investing in growth (advertising and R&D) or begin a measured shift toward operating as a maturing business (share repurchases and/or dividends)? Can management be trusted not to burn cash on questionable acquisitions?

As for Factor #2, without the singular brilliance of Steve Jobs, I cannot conclude that there is a high probability that Apple will produce another revolutionary product(s). Neither can I rule it out, as there are plenty of great technologists on board. As much as I like my i-Phone, Apple as an investment is too hard for me.

Grahamites
Grahamites premium member - 3 months ago

Jtdaniel: First of all, thank you for the nice words.

To address your comments, I think here we really have a paradox: very often you can find objective answers to easy questions such as how much Apple is spending on R&D and advertising and how fast Apple has been growing historically. These are what I call the easy lay-ups and widely known. Are they important? Somewhat but I wouldn't bet my investment thesis on these easy lay-ups. Unfortunately this is where most investors stop because just like you have experienced, it's very hard to come up with an objective answer to the questions that are ultimately most important. But do we need a definite answer to those questions? In some cases we do, in some cases we don't. As I've posted in my previous article, we may not know the definite answers, but we can come up with probabilities and by applying probabilitstic thinking, we can then come up with an expected value. If you can't come up with different scenarios or assign proper probabilities, then you may want to put this investment into the "too-hard" pile. This is what you essentially concluded. Apple is too hard for you. And this is also the point of handicapping, if you don't know the answers to the most important questions, why bother going further? I think you've mastered the concept.

Again, I appreciate the compliment as well as the thought-provoking feedback.

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