Outcomes Versus Reasons - Part II

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Jun 22, 2015
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In one of my previous articles, I discussed the importance of separating results from reasons. In it, I stated the following:

“One of the things that I find absolutely fascinating in the investing world is that most investors judge whether an investment decision was right or wrong solely by the outcome. If the outcome is favorable then the decision was a great one and if the outcome is adverse, then the decision was a poor one. What is often neglected is the fact that in life and investing, we are often “right for the wrong reason,” or “wrong for the right reason.”

Then I listed the 5 possible combinations of results and reasons.

  1. Right result for the right reason – skill only, no luck needed or very little luck needed.
  2. Right result for the wrong reason – undeserved lucky.
  3. Wrong result for the right reason – skill but unlucky.
  4. Wrong result for the wrong reason – deserved unlucky.
  5. Whether the result or the reason is right or wrong cannot be reasonably assessed – a clear sign of out of circle of competency.

In the end, I suggested that “to achieve satisfactory returns and superior returns, especially superior returns, one has to improve his batting average in the ‘right for the right reason’ or ‘wrong for the right reason’ camp.”

Someone asked me this question: Forget about the reasons, how do we know whether we are right or wrong in the first place?

This is not an easy question. From my observation, 99% of the market participants judge whether the decision was right or wrong by one single factor – the price movement (especially) of the underlying security. If someone pitched a long idea and the price of the stock moved up say 20% during the next few days, weeks or months for whatever reason, he or she will be considered to be right. And vice versa.

This predictable irrationality caused by a combination of reinforcement and social proof is one of the most under-appreciated concepts in the investing world. Of course human nature makes us use the price movement to judge whether we are right or wrong. The price of a stock is readily available whereas other data may take a while to find. The movement of the stock is vivid. Then we are inclined to pound in what we shout out. Ultimately, we feel secure and comfortable when the whole investment community agrees with us, and insecure and horrified when the herd is against us. It’s a lollapalooza.

So what? Then what? How do we insulate ourselves from this folly?

The first step is to invert, always invert. If the wrong thing is to focusing on stock price and the movement, why don’t we just ignore the prices?

Then we need to come up with alternative options. I’ve repeatedly suggested that a simple approach to think about returns is to look at the returns from the components – fundamental growth, capital return and multiple change. Naturally, this leads to the following set of questions:

  1. Are you right about the fundamental growth?
  2. Are you right about the amount of capital that can be returned to shareholders?
  3. Are you right about the multiples you can pay for the business and still be able to earn a satisfactory return?

You can answer the first two questions by tracking the quarterly and yearly financial results. The third question is tricky. The right multiple depends on the fundamentals of the business, and required return. Each investor has different fundamental growth expectations and return expectations. A 15% required return translates into a much lower multiple than a 10% required return.

A simple statement like this may be a worthwhile exercise for tracking purposes (note I used hypethetical numbers, not actual numbers): I think Pepsi (PEP, Financial) will grow earnings 8-9% a year for the next 10 years and will pay out half of the earnings to shareholders, which at the current price will translate into roughly a 3% yield. My required return for any investment in this interest rate environment is 12% so if I pay a fair value multiple, I can get my 12% return at the end of the 10 year.

It is inherently harder to assess whether you are right or wrong in the short term because there is a great deal of randomness in short term. The randomness is more likely to be flushed out if you stretch your investment horizon to 5-10 years. Furthermore, the more predictable the business is, the narrower the range of the likelihood is and hence, the easier it is to judge whether you are right or wrong. If the range of the likelihood is very wide, such as it is for some technology companies (LNKD and YELP for instance) and commodity businesses, it will be very hard to tell whether you are right or wrong.