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Robert Abbott
Robert Abbott
Articles (798)  | Author's Website |

Book of Value: Investing as a 'Negative Art'

From Aristotle to a test of value investing fundamentals

March 13, 2020

How do we know what we know? How do we know what we think we know? As investors, we confront these questions whenever we buy or sell.

Philosophers throughout human history have tried to find truth and ways to separate truths from falsehoods. In chapter six of “Book of Value: The Fine Art of Investing Wisely,” Anurag Sharma summarized how several outstanding thinkers of the past two millennia have sought to do just that.

This made up a key part of Sharma’s bid to build a new investment theory, one that emphasizes the role of independent, if not always rational, buyers and sellers of stocks. As he noted, it is essential to understand this thinking if we want to invest well.

In chapter six, he discussed the work of four philosophers who have had a pronounced impact on the way we think about what we know or think we know. They were Aristotle, Rene Descartes, Francis Bacon and Karl Popper.

Aristotle laid out a systematic approach to testing whether something might be true or untrue. Sharma offered this example of Aristotle’s reasoning: All men are pious, which is the major premise. Rob is a man, which is the minor premise. The inference that can then be drawn is that Rob is pious. As the example suggests, much depends on the truth of the two premises.

Descartes did not try to confirm knowledge as Aristotle did; instead, he tried to disconfirm false knowledge and ideas.

Among those who were dissatisfied with Aristotle’s approach was the seventeenth-century scientist Francis Bacon. As Sharma explained, Bacon argued that premises should not be taken for granted. Instead, they should be based on real, observable data. According to Bacon, pure deduction was not enough because people’s minds contain “deep-rooted false notions.” In other words, he recognized the place of emotions and biases in our thinking.

A more recent analytical shift in conceptualizing how we know if something is true or not came from an Anglo-Austrian philosopher named Karl Popper. According to Sharma, Popper flipped the Baconian position on its head by trying to falsify a hypothesis rather than by collecting evidence to prove it. From another perspective, there is never enough evidence to prove a hypothesis, but a single fact can disprove it. For Sharma, Popper’s thesis marked an important turning point.

"We now have a method with which to tackle the frailties of the human mind. As investors, we must take heed,” Sharma wrote. "So, negation is the approach we will take to frame investment decisions.”

For those who want to learn more about knowledge and how we think about it, I would recommend a dip into a discipline known as epistemology. The PhilosophyBasics website defines this field as, “the study of the nature and scope of knowledge and justified belief. It analyzes the nature of knowledge and how it relates to similar notions such as truth, belief and justification.”

In chapter seven of "Book of Value," the author introduced investing as a “negative art.” Sharma began the chapter by pointing out that Benjamin Graham and David Dodd were aware of psychological issues when they wrote “Security Analysis.” Graham and Dodd called the selection of bonds a negative art because the potential for gains and losses was badly out of balance. Sharma went a step further by saying he would extend that imbalance to all securities, including stocks.

He reasoned that the hope of gain intensifies confirmation bias, and therefore we ignore investment dangers and behave like speculators. We humans are attracted to the possibility of big gains; just witness how the long the lines become when lottery prizes rise to absurdly high levels. Confirmation bias means we favor information that supports our previously held beliefs and reject information that does not support our beliefs. Once we really convince ourselves this lottery ticket or this hot stock will make us rich, we throw caution to the wind and buy the ticket or stock without considering the potential for loss.

For Sharma, Popper and Graham were working on two facets of the same problem. For Popper, it was drawing a distinction between science and nonscience. For Graham, it was drawing a line between investment and speculation.

In a cross-seeding exercise, Sharma called investment opportunities speculative when the premise on which they’re based cannot be set up for refutation. We might replace the word “refutation” with falsification or disconfirmation.

Let’s now apply this to the analysis of a stock. You begin with the thesis or hypothesis that stock XYZ is a good stock. But theses and hypotheses are meant for testing, so you create a series of sub-theses that might include earnings per share, cash flow, debt levels and so on. You then try to disconfirm these sub-theses by reviewing the data and perhaps by using tools such as discounted cash flow modeling.

According to the author, stocks should not necessarily be rejected because they fail one or more tests, but, “you try to disconfirm it on an overall judgment based on the totality of tests.”

For a complementary view on falsification or disconfirmation, see Thomas Macpherson’s GuruFocus article, “Getting to Zero: Value and Risk Management”. In the article, he explained how he tries to break the case for buying a stock:

“After we’ve gotten comfortable with a possible investment, we will generally deconstruct our business case and pressure test them in five ways: revenue, credit/debt, management, competitive moat, and regulatory. The goal in each is to find what events and/or assumptions are required to break the business in terms of strategy, operations and financial performance.”

Conclusion

Chapters six and seven of “Book of Value: The Fine Art of Investing Wisely” continue to guide us toward the author's goal of an investment theory that includes a robust serving of behavioral finance.

He provided an overview of the philosophical approach to finding truth through the works of Aristotle, Descartes and Francis Bacon. Most importantly, he alerted us to the works of the philosopher and scientist Karl Popper.

Popper gave us an easier way to test a hypothesis, which is through falsification. Sharma used the idea of falsification to provide an initial model for testing an investment idea. That was to create a set of sub-hypotheses that assess an investment’s fundamental metrics.

Disclaimer: This review is based on the book, “Book of Value: The Fine Art of Investing Wisely”, by Anurag Sharma, published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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