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Why is That? And How do you Judge That?

May 12, 2014 | About:
Grahamites

Grahamites

130 followers

I was lucky enough recently to hear from Mr.Chuck Akre (Trades, Portfolio) at the Value Investor Conference in Omaha. The detail of his presentation can be found in one of Gurufocus' recent articles. Today, I want to share with the readers what I found most remarkable about Mr. Akre's presentation - the two questions that made me ponder day after day after his presentation: Why is that? How do you judge that?

Here is a recap of Mr.Akre's interaction with the conference participants:

Mr.Akre: So let me ask you what is a good investment?

Audience A: High return on capital.

Audience B: Margin of Safety.

Mr.Akre: How do you judge that?

Audience B: ......

Audience C: Low price compared to intrinsic value.

Mr.Akre: How do you judge that?

......

Mr.Akre:Stocks have been returning about 10% annually for the past 75-100 years, but why is that? MasterCard and Visa have very high net profit margin compared to average American businesses? But why is that?

......

Mr.Akre asked these two questions over and over again during his presentation. It's probably part of his investment routine. It's not complicated. It's actually very simple.

This ties back to the simplicity principle I wrote about a few weeks ago. Your investment thesis should be simple but at the same time, you should have gathered enough information to support your thesis. The question "why is that?" will direct you to the most important factors and the question "how do you judge that?" will direct you to collect the most important information.

Let me illustrate through an example. Let's say you think Berkshire Hathaway is a great investment. Following Mr.Akre, you should ask yourself "why is that?"

The most logical answer is that Berkshire Hathaway is a great investment because it offers sufficient margin of safety at the current price and its intrinsic value will most likely to grow at double digits per year in the future.

Then you should continue asking yourself: "How do I judge the margin of safety here and why is that Berkshire Hathaway can grow its intrinsic value at double digits in the future?"

This gets you to the next level of thinking. First, you will likely to find out that you can judge the margin of safety by comparing Berkshire's current price per share to book value per share. If the ratio is low, it is likely to be cheap. The next question becomes why is book value a good indicator of Berkshire's intrinsic value? Why not earnings? Why not sales? The question list goes on and on but in a few more questions, you will likely find out that you have reached the point where you have simplified the problem to the most fundamental level.

Now you repeat the process for the second part of the question from the previous layer - why is that Berkshire Hathaway can grow its intrinsic value at double digits in the future? You then find out that Berkshire has been growing its intrinsic value at close to 20% per year since inception. The next question again becomes "why is that?" "Can they continue to achieve that rate of growth and how do I judge its future performance?" Keep asking why, why and why until you can go no further - try to reduce to the most fundamental and crucial level.

I used Berkshire Hathaway as an example because most people are familiar with the business. Start with a company you are less familiar with, repeat this exercise a few times, you may be amazed.

Keep in mind that you have to avoid getting into a situation where you just keep asking questions without getting somewhere. Personally, I have found the following advice extremely helpful from Richard Feynman:

“But the game is to try to figure a thing out, with what we know is possible. It requires imagination to think of what’s possible, and then it requires an analysis back, checking to see whether it fits, whether it’s allowed, according to what is known.

When you explain a ‘why’ you have to be in some kind of framework where you allow something to be true, otherwise you are perpetually asking ‘why?

Hypotheses should not be multiplied without reason. In other words, look for the most simple reason."

Of course this is all easily said than done. Asking the right questions in the right direction is more art than science and find the answers to those questions may require tremendous effort. But if you keep doing that, you will find yourself thinking in another level in terms of investment analysis.

Thank you for reading.


Rating: 4.9/5 (14 votes)

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Comments

boutch2fr
Boutch2fr - 5 months ago

Thanks. It reminds me of the method of the "5 whys"

Grahamites
Grahamites premium member - 5 months ago

Boutch2fr: My pleasure. Thanks for the link of the method of the 5 whys. I've actually not heard of it before so thanks for the ignorance removal:)

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