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How Good Is Your Evidence?

June 13, 2014 | About:
Grahamites

Grahamites

112 followers

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. -Ben Graham

One of the most important skills an investor can develop is analytical ability. There are numerous definitions of analytical ability. To me, it means collecting and interpreting all types of evidences in a way that leads to sound and logical decision making.

From the above definition, you can guess that I place an enormous amount of importance on the quality of evidence. I think the quality of evidences is one of the differentiating factors in investment decision making.

What is evidence then? Well, according to the dictionary, evidence means "the available body of facts or information indicating whether a belief or proposition is true or valid." I can't think of a better definition but my experiences have taught me that in investing, knowing this definition is far from enough because we have to differentiate among different types of evidence.

Again, different investors will have different categorization systems of evidence. I myself categorize evidence into the following groups:

1. Intuition: immediate opinion without the need for conscious reasoning.

2. Personal experiences and observation.

3. Facts and other information easily available and widely known.

4. Extra vivid facts and other information.

5. Facts and other information available only through diligent and painstaking efforts.

6. Evidence and convictions borrowed from others.

I've read numerous lengthy investment write-ups that contain all the above types of evidences. Obviously I prefer group five above - facts and other information obtained through diligent and painstaking efforts. Unfortunately, 80% to 90% of most write-ups are spent on the other five categories, which is understandable given how human brains work.

As always, let me walk through an example. Say you want to analyze the common stock of Amazon.com. What would be examples of different types of evidences?

1. Intuition. Everyone will have an immediate opinion about Amazon. When I asked one of my previous colleagues what he thinks about Amazon's stock, he said, "It's such a great business that you can't really go wrong with it." This is typical intuition-based false evidence and if you think my previous colleague is alone in that camp, turn on your TV and watch CNBC for a while.

2. Personal experiences and observation, which often create extra vivid facts and other information. In other words, these two often go hand in hand. You use Amazon's Prime Membership and you observe your friends enjoy their kindles. You like Amazon's Prime Membership, each time you enjoy the Prime Membership, you are pounding in vivid positive pictures, which will be easily available to you when you think about Amazon's stocks. You observed your friend's fascination over his kindle and again, you are pounding in vivid information so easily available to you. I'm not saying evidence of these types are necessarily bad, but you have to be fully aware that we tend to overweight vivid evidence that is easily available.

3. Facts and other information available and widely known. I've touched on this point a little bit in the above paragraph. This is the type of evidence that often does an investor in. I was discussing Amazon with a friend of mine very recently. He said he wouldn't buy any stock that has a P/E ratio of over 500. Well, Amazon's TTM GAAP EPS of $0.64 and implied P/E ratio is readily available on Google Finance or Yahoo Finance. It is also widely known that Amazon's not making much profit and Jeff Bezos doesn't care about short-term profitability. This is where most investors stop. After all, why invest in a stock with an extremely high P/E and not making serious money in the next one or two years?

4. Borrowed evidence or convictions. A quick check on GuruFocus reveals that a few gurus, including Tom Gayner (Trades, Portfolio), George Soros (Trades, Portfolio) and John Burbank (Trades, Portfolio) bought Amazon during the past few quarters. If you follow any of them, you may initiate a position in Amazon after they did. You then read their comments on Amazon and you think you have solid evidence backing up your investment. This is a very dangerous type of evidence. How often do you buy a stock without spending much time researching it just because other gurus bought it? Sometimes you may get lucky say if you follow Seth Klarman (Trades, Portfolio)'s Idenix investment all the way. Sometimes you get what you deserve say if you follow Bill Ackman (Trades, Portfolio)'s J.C. Penney's investment. I don't have a problem with being a copycat but I don't think it is wise to blind copy someone else's idea without doing your own research. I certainly think it's despicable to complain about either selling too early or having lost money by blindly following other's ideas without doing your own proper due diligence.

5. Facts and other information available only through diligent and painstaking efforts. No surprise here, this is my favorite type of evidence. In the case of Amazon (AMZN), it means reading the annual reports for the past eight to ten years and everything else you can read about Amazon so you can understand the business and assess the true earnings power of the business. Below are examples of this type of evidence obtained from going through Amazon's annual report since 2005.

  • In 2005, fulfillment cost was 8.8% of sales and during the most recent year (2013), it is 11.5% of sales, which by itself has nonupled since 2005.
  • Amazon spent heavy in technology and content, which was only 5.3% of sales in 2005. Now it’s 8.8% of sales.

Here is an example of another evidence not easily available:

  • Businessweek recent published an article about IBM but it told the story of how the CIA had chosen Amazon Web Services over IBM to build a version of its public cloud that runs inside the CIA's data center.

By gathering evidence like the above, I am comfortable to conclude that Amazon's true earning power is much, much higher than the GAAP figure, which is easily available. How much is Amazon's true earning power? I doubt even Bezos knows the exact number.

One thing I want to point out is that we are all subject to excessive self-regard tendency. Therefore, very often we think we know something others don't but in fact it's not the case. My antidote is to send your evidence to a few of your trusted friends. If they come back to you with quick agreement, you are likely to have found something widely known.

Conclusion:

Human tendencies make us vulnerable to use evidence that is likely not adding too much value to our investment thesis. Therefore, I suggest adding the following item on your investment checklist:

  • What types of evidence am I using and how good are they?

This question will force you to go through the process of evaluating the quality of your evidences which may lead to second thoughts.

The investor's chief problem - and even his worst enemy - is likely to be himself.

- Ben Graham


Rating: 5.0/5 (8 votes)

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Comments

varunfriend
Varunfriend premium member - 1 month ago

Nice article.

In terms of thinking differently here's a presentation by Josh Tarasoff that I found to be very enlightening that is a good example of #5

http://csinvesting.org/wp-content/uploads/2012/08/amzn-valuexvail-2012-josh-tarasoff1.pdf

Grahamites
Grahamites premium member - 1 month ago

Varunfriend: Thanks for the nice words and thanks for the great presentation on Amazon. It is indeed very enlightening and a good example of #5. Thank you.

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