The Importance of Reading and Deductive Reasoning in Investing

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John Emerson
Aug 29, 2011
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"In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time none, zero. You'd be amazed at how much Warren reads at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out." ~ Charlie Munger


The above quote is an area which is rarely discussed in value investing, specifically the need to acquire worldly knowledge to become a truly successful investor. The accumulation of broad knowledge is imperative in allowing the investor to ask the correct questions when evaluating a stock.


I am always amazed when I listen to Warren Buffett do an interview or read through one of his old annual letters. The man is a walking, talking Wikopedia. While few of us possess his learning acumen, most of us have the ability to add to our worldly knowledge on a daily basis. The information revolution has put the ability to learn literally at our finger tips.


Businesses are much more than the set of trailing financial statements which they produce; they are dynamic rather than stagnant in nature. Even the simplest businesses are subject to a broad range of external factors which are largely beyond the control of management. The amount of general knowledge an investor holds correlates directly with his/her ability to identify undervalued sectors and companies, as well as increasing one's ability to access the risks which are involved in the business. An example is in order.


Bill Gates Call on Kodak (EK, Financial)


In The Snowball, the autobiography of Warren Buffett , Alice Schroeder recalls a story about Bill Ruane asking Bill Gates about his view on Kodak in 1991. Gates is said to have called the company "toast."


Of course at that time almost no one but Gates could have foreseen the advent of digital photography and its ultimate effect on the film camera industry; however, a decade later anyone who owned Kodak had little excuse for not at least acknowledging the threat.


Any avid reader or camera bug, let alone a Kodak investor, had every opportunity to visualize the impending doom which faced businesses which relied upon traditional film.


The chart of EK reveals the effect of the digital camera on the profits of the company.





The earnings collapse in EK started in 2004 but investors still had several years to jettison the stock before the death spiral set in.


Income Statement - 10 Year Summary (in Millions)




Sales


EBIT


Depreciation


Total Net Income


EPS


Tax Rate (%)


12/10


7,187.0


-561.0


378.0


-675.0


-2.51


0.0


12/09


7,606.0


-117.0


427.0


-233.0


-0.87


0.0


12/08


9,416.0


-874.0


500.0


-727.0


-2.58


0.0


12/07


10,301.0


-257.0


785.0


-208.0


-0.72


0.0


12/06


10,568.0


-583.0


1,195.0


-804.0


-2.8


0.0


12/05


11,395.0


-1,208.0


1,291.0


-1,657.0


-5.76


0.0


12/04


13,517.0


-113.0


1,031.0


69.0


0.24


0.0


12/03


12,909.0


104.0


867.0


189.0


0.66


-81.73


12/02


12,549.0


894.0


834.0


761.0


2.61


14.88


12/01


13,229.0


115.0


933.0


81.0


0.28


29.57




Deductive Reasoning and Investing


Value investing is largely an application of deductive reasoning where a premise is identified; then, a logical conclusion can be inferred by examining the likely consequences of the premise. Bear in mind that the validity of the deductive reasoning process in a direct result of the accuracy of the premise. Garbage in results in garbage out.


In the case of Kodak the premises for the argument would have been as follows:


A) The advantages of digital cameras far outweigh the advantages of traditional film cameras for the average consumer.


The logical conclusion:


B) Consumers will choose digital cameras over film cameras in the near future.


The next premise:


C) Kodak's current business model relies upon continued sales of film cameras.


The logical conclusion:


D) Kodak's current business model will become obsolete in the future.


While things are always much clearer in hindsight, the illustration points out the need for investors to constantly monitor the dynamic nature of the businesses which they intend to purchase or the ones which they continue to hold. That process can only be accomplished by a self-education process and that process is a direct result of ongoing reading and study. Think of investing as a commitment to lifelong learning.


The aforementioned process is the most under appreciated essential point of successful value investing; not surprisingly, the procedure is rarely practiced by most investing professionals. Yet these professionals provide the advice to the "Average Joe" who places a large part of their retirement saving in their hands.


If an investor or adviser does not accumulate sufficient knowledge to accurately identify an investment premise and the risks associated, their investment results will become a direct function of chance rather than skill. It is not satisfactory to merely possess an extremely high IQ, and even the logical skills of Sherlock Holmes become woefully inadequate, if one does not spend the research time necessary to identify a valid premise. How can one hope to be successful if they do not possess the necessary knowledge to ask the correct questions when assessing whether the financials of a company represent a value or a value trap?


Summary


It is paramount that investors pursue a lifelong learning strategy if they hope to outperform the market. The continual accumulation of worldly knowledge uncovers new investing opportunities as well as aiding in the assessment of risk in other businesses.


Value investing is largely an exercise in deduction reasoning. The key to the process is uncovering valid premises and then thinking them out to their logical conclusions. It is nearly impossible to draw out a valid premise if an investor does not continue to accumulate knowledge on a regular basis.


It is imperative that an investor pay continuous attention to the dynamic nature of the businesses which they hold. In the case of Kodak, investors literally had years to jettison the stock before the death spiral of negative earnings caused by the advent of digital photography destroyed the price per share of the stock.
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I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.