Is This Stock Undervalued?

Reflect on the last 24 hours of your life. How many times did you find that you did not know how to answer a particular question? How many times did you wonder if you had sufficient facts to answer or give an opinion on an issue? How many times did you tell yourself or the people around you that you just did not know?

If you are like most of us, probably not too often. Our mind is a wonderful entity which comes up with views, opinions, decisions, projections, hypothesis, narratives and judgements without much effort. It has an opinion on everything, even when it has no justifiable reasons to form one. On top of that, consider that most of the questions you encounter during (a day in) your life are ill-defined and you probably don’t have the relevant data to answer them correctly and precisely.

In most cases, this is not something one should be worried about. Most of the time our mind correctly and seamlessly fills up the missing pieces and comes up with an answer which is not far from a reasonable answer given the circumstances. But this may spell doom when it comes to investment process and decisions.

Here is an example. Consider the question:

How happy are you with your life these days?

If we think about it, this is a difficult question and ill-defined at that. Even after agreeing on what “happiness” means we have to make a judgement on what “these days” means and subsequently guess if we were mostly "happy" or "unhappy" during this period.

But as soon as you read the question, you had an answer ready for it. You safely ignored all the ambiguities and came up with an answer, a judgement on your general happiness “these days.” But did you answer the question you were asked or substitute (unknowingly) this difficult question with an easier one ("what is my mood right now?") and answer that? I dare say that you “substituted” and answered the easier question without realizing that you did so.

Daniel Kahneman recounts a story which explains why this is important for the investment process.

“Many years ago I visited the chief investment officer of a large financial firm, who told me that he had just invested some tens of millions of dollars in the stock of Ford Motor Company. When I asked how he had made that decision, he replied that he had recently attended an automobile show and had been impressed. ‘Boy, do they know how to make a car!’ was his explanation. He made it very clear that he trusted his gut feeling and was satisfied with himself and his decision. I found it remarkable that he had apparently not considered the one question that an economist would call relevant: Is Ford stock currently underpriced? Instead he had listened to his intuition: he liked the cars, he liked the company, and he liked the idea of owning the stock.”

The story offers an example of substitution which is relevant to us. Instead of answering, “Should I invest in Ford stock?” the executive answered the question, “Do I like Ford cars?”

Arguably, the first question is much more difficult than the second one. We need a lot of data and some dirty work to come up with an acceptable statement about the pricing of Ford stock. But the second question is easier to answer. We have to make a decision about our likeness of a particular brand of cars and the answer comes naturally without much mental work.

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We live in a complex world surrounded and bombarded by ever-changing information, data, opinions, analysts recommendations, sales figures, earning summaries, reports, proxies and what not. Our brain sorts, classifies and files the information we take in (and thankfully sometimes forgets it). The depth and breadth of this stored information is fantastic. Let us try a thought experiment here to make the point sink in.

Think of the company Microsoft (MSFT, Financial). How much information can you pull up from your brain about it?

If you think for a while, you can fill up page after page with information on Microsoft. You would start with something like, “Microsoft was founded by Bill Gates and Paul Allen and is an OS company based in Redmond, Washington...”

As soon as the name of Bill Gates comes to your mind, you remember information about Bill Gates. “He is the richest man, and at one point owned the most expensive house in the world ... Melinda Gates Foundation ... friend of Buffett ...” Granted, some of this information will be pure fiction; nevertheless you have stored it in your brain and can draw on it when needed.

This is nothing short of amazing. And remember that we have information about many other companies and topics which are outside the finance realm. Books, movies, actors, singers, songs, illness, philosophy, mathematics, physics, the universe and so on. It is hardly surprising that our brain simplifies and finds connections to make facts easier to ingest and remember.

Our brain loves a plot, because a plot is a way to weave information and make it less random. A pertinent example comes from the novelist E. M. Forster. Consider these two sentences:

The king died and then the queen died.

The king died and then the queen died of a broken heart.

The first one is two separate pieces of information. The king died and then the queen died. The second is just one piece of information. The king died. The queen dying of a broken heart is not entirely alien to us. The second is easier to explain, remember and is hence less random.

Forster famously said that the first is a story but the second is a plot because the latter has a causal as well as an emotional connection. This “easier to remember” and “less random” second line has a serious side effect which is connected to the “substitution” problem described above.

An experiment was conducted by Kahneman and Tversky:

Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.

Which is more probable?

1. Linda is a bank teller.
2. Linda is a bank teller and is active in the feminist movement.

Around 90% of the people who were asked this question chose option 2. Clearly, option 1 is more encompassing than option 2. Linda can be a feminist or not if she is just a bank teller. So, option 1 is more probable.

Similarly, if you are tested on E. M. Forster’s two lines, “The king died and then the queen died,” versus “The king died and then the queen died of a broken heart,” your gut reaction is to think that the second situation is more likely. On the other hand the first line includes dying of broken heart along with going mad, falling ill or falling from the balcony of the palace.

If you think about it, this is a case of substitution. You are not really answering the question “which is more probable?” but you are answering the question, “Which situation explains the fact with higher probability?” Linda who is a bank teller and feminist is more likely to fit the description than Linda who is just a bank teller.

But did we notice what was going on? No!

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How does this affect our investment decisions?

If you read and thought about this carefully, you probably have already realized that “substitution” has grave implications for our investments.

Before investing in a stock we need to answer the all-encompassing important question: "Is the stock undervalued?" But most of the time we end up substituting it with different, easier-to-answer questions. “Does Warren Buffett like it?” is one such question. “Is the market overreacting?” is another. “Does the company have a strong balance sheet and good products?” is a more to-the-point question.

All the substitutions you see here are easier to answer. It is quite easy to verify if Buffett is buying the stock, or if the market has suddenly pushed the price up/down significantly. It is also easier to verify if the company has a strong balance sheet and likeable products than to actually answer the original question “Is it undervalued?”

The importance of a checklist should be quite clear at this point. A checklist should consist of easier-to-verify questions. Otherwise, substitution may take place inside a checklist, too. A list will force you to answer questions in a step-by-step fashion, and make it easier to catch if a substitution does occur.Also check out:

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• Stocks that Bill Gates keeps buying