One of my favorite chapters of the book “The Most Important Things” is Chapter 14 – "Knowing What You Don’t Know." In it, Howard Marks (Trades, Portfolio) shrewdly pointed out the following:
“Awareness of the limited extent of our foreknowledge is an essential component of my approach to investing.
“Investment results will be determined entirely by what happens in the future, and while we may know what will happen much of the time, when things are 'normal,' we can’t know much about what will happen at those moments when knowing would make the biggest difference.
“Whatever limitations are imposed on us in the investment world, it’s a heck of a lot better to acknowledge them and accommodate than to deny them and forge ahead.
“Acknowledging the boundaries of what you can know – and working within those limits rather than venturing beyond – can give you a great advantage.”
Unfortunately I did not heed the above valuable lessons from Marks. I had to learn the hard way – by mistakes. While Marks mostly referred to the macro unknowables and the uselessness of macro projections, his wisdom also extends to the company-level analysis, which he did not discuss much in the chapter of his book. I’ve personally learned that there’s so much we don’t know about a company and the ecosystem it is in. Yet we often operate in a way that implies that either we know or we don’t know that we don’t know.
Most value investors claim that they are contrarians, which means they deviate from the consensus view, which can be wrong in two ways – the earnings estimate can be off or the valuation multiple can be off. They buy the stock of a company because they think the consensus is too pessimistic and they sell the stock when they think the consensus is too optimistic. But I’ve learned that being a contrarian has nothing to do with being a great investor. The difference is a great investor knows when to be a contrarian and when to be a conformist whereas a less successful value investor doesn’t. A vast majority of the time, the consensus view is very efficient, especially in the U.S. For someone to claim that the consensus is wrong, he or she better come up with some damn good evidence to support the hypothesis. In fact, I’d say the Wall Street sell-side analysts know a lot more about a company and an industry than a retail investor.
Most of the time, we see superficial, or first-level evidence when someone claims to think the consensus is wrong. And most of the time, the argument includes the word “should” and the word “if.” The shares should be higher if things get back to normal. The bad result should be a one-off event. If oil price gets back to $80 a barrel, we should make a lot of money. These are the types of arguments I would make awhile ago when I was tempted by a stock that fell to say a 52-week low.
In an article I wrote in June 2014, I listed out the six categories of evidence:
- Intuition: immediate opinion without the need for conscious reasoning.
- Personal experiences and observation.
- Facts and other information easily available and widely known.
- Extra vivid facts and other information.
- Facts and other information available only through diligent and painstaking efforts.
- Evidence and convictions borrowed from others.
If you can back up the hypothesis that the consensus is wrong using category five evidence above, you’ve earned your right to tell your second-level opinion, which is different and better than the consensus opinion. But if you use the other five categories of evidences to form your opinion, you are not being a contrarian for a good reason.
In another article I wrote in June 2014, I said the following:
“I became a better investor because now I realize that we should not form an opinion too quickly without having done the research to know enough about a company. I feel comfortable to acknowledge that I don’t know enough to have an opinion on most stocks traded on the New York Stock Exchange. When I do have an opinion on a stock, I’d like to have what I call the second-level opinion, which is opinion well thought and properly backed up. This is a little different from Howard Marks'Â second-level thinking because a second-level opinion doesn’t need second-level thinking. It only requires doing the proper amount of research to have an educated opinion. That’s it.
“If you start cultivating the habit of forming second-level opinions and refrain yourself from expressing first-level opinions, which are often intuitions, you may be able to possess the second-level thinking ability eventually. All the pains you have to go through and all the efforts you have to make to consistently have second level opinions will most likely make you see things clearer and better in the end.”
I still think the above holds true. In the words of Steve Jobs, “Stay hungry and stay foolish.” We are much more ignorant than we think we are, and “ignorance removal should be a moral duty,” to quote Charlie Munger (Trades, Portfolio). Therefore, we should operate on the hypothesis that we don’t know enough unless proven otherwise. Acknowledging that most of the time, we don’t know whether the consensus view is right or not is a sensible lesson to which I hope we all can stick.
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