Value Talk by Charles Mizrahi. “You don’t need a lot of information to make a decision on investing in a good company. Too much information doesn’t improve accuracy and instead can make you overconfident when you have no reason to be.” And his analysis on Graco, Inc.
Less is Best, on Graco, Inc.
Mae West, legendary movie star and sex symbol of the 1930s and 1940s, said that “too much of a good thing can be wonderful.” I’m sure that most people would agree. In fact, Warren Buffett used her quote when writing about taking meaningful positions in businesses that he has a long-term conviction for.
With so much information available about a company and its stock price, how much information do you really need in order to make a decision? Is too much information a wonderful thing when it comes to selecting stocks to buy? To be good investors, most people have the image of a bespectacled analyst sitting at his desk piled with financial statements and working way into the night. After many hours of crunching numbers in spreadsheets that are filled with complex formulas, our hardworking analyst has a eureka moment after plowing through scores of financial variables and finds that the company’s stock is trading at half the value of the underlying business. If that is your image too, after you read this month’s letter I’m sure you will change your views on how much data you really need in order to analyze a business.
Science or Storytelling
Although I wasn’t born in Missouri, the Show Me State, in this life, I must have been born there in a previous life. I need to see credible studies done in a scientific setting before I accept something as fact. It never ceases to amaze me how many people so readily would believe a story over scientific fact. I see that a lot in people who ingest huge amounts of nutritional supplements. Although most scientific studies have shown that supplements have no effect and sometimes can be harmful, these people still cling to their belief. In other words, they are willing to accept storytelling over science.
If you ask the average stock analysts how much information they need to evaluate a stock, I’m sure you will hear numbers that reach into the mid teens and higher. The Value Line Investment Survey has been published for over 70 years, and tracks 1,700 stocks. A Value Line stock page provides a wealth of information on a given company. The page has over 50 pieces of information. In the statistical array table alone there are 23 different pieces of historical financial data going back at least 10 years. Looking at the Value Line page for the first time can be very intimidating when trying to value a business. But have no fear, you don’t have to focus on all 50 pieces of information. In fact, studies have shown that more is truly less in this case.
Using experts in a variety of fields as test subjects, experimental psychologists have examined the relationship between the amount of information available to the experts, the accuracy of judgments they make based on this information, and the experts’ confidence in the accuracy of these judgments. They did the experiments by controlling the information they made available to the experts and they checked the accuracy of their judgments based on that information.
And They’re Off…
One such experiment was done on horse handicappers. Similar to stock investing, there is a myriad of past performance data on horses. For this experiment, they chose eight experienced horse handicappers and showed them a list of 88 variables found in publications like the Daily Racing Form. Data such as races won, speed ratings, weights carried, etc. are published on each horse. Out of the 88 variables, each handicapper was limited to using only five variables that they felt had the greatest importance to handicap a race. They were then asked to limit their selection to the most important 10, 20 and 40 variables.
After they selected their most important variables, they were then given true data (no way for them to identify the horse and the actual race) for 40 past races and asked to rank the top five horses in each race in order of expected win. Each handicapper predicted each race four times–using 5, 10, 20 and 40 variables. In order to measure the confidence of their selections, each handicapper was asked to assign a value to their prediction from 0 (not confident) to 100 (a sure thing).
The result of the handicappers’ predictions compared to the actual results was counterintuitive. The accuracy of the predictions remained the same regardless of how many variables they used. In other words their accuracy using 5 or 40 variables was more or less the same. However, as the number of variables used increased, so did the confidence level of their judgments. They had more confidence in their selections when they used 40 variables than when they used fewer variables, yet their accuracy remained the same. The more data they used to predict the outcome of a race, the more confident they felt about their selection.
The results were not isolated to horse handicappers. Similar tests were done on clinical psychologists asked to make judgments on subjects, medical doctors asked to diagnose patients, and stock market analysts asked to make long-term predictions on stocks. The conclusions were all the same; the accuracy of their predictions was similar regardless of variables, yet the more variables used the more confident they were about their predictions. The conclusion from these studies was an eye opener.
Experts overestimate the importance of factors that have only a minor impact on their judgment and underestimate the extent to which their decisions are based on a few major variables (editor-italics mine). [T]he analyst is typically unaware not only of which variables should have the greatest influence, but also which variables actually are having the greatest influence.
Buffett’s Four Filters
While researching these studies and reading the conclusions, it didn’t come as too much of a surprise to me. Over 30 years ago, Warren Buffett wrote that he only uses four variables when selecting a stock or a business for acquisition:
We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.
What is notable is that over the past three decades, when asked the same question, Buffett has always been consistent about the four variables he uses. If a business or equity can pass through all four filters, Buffett takes a sizeable position.
The Moat
One of the variables that most investors have trouble identifying is finding a business with favorable long-term prospects. Buffett has spelled it out over the years and now refers to it as a business with an enduring competitive advantage, or moat. Patrick Dorsey, Morningstar’s director of research, recently came out with The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments (Wiley 2008). In it, he answers the question of how one can accurately identify companies that are great today and likely to remain great for many years to come.
By being able to identify a company’s competitive advantage and purchasing its shares at reasonable prices, one can build a portfolio of solid businesses that will be worth more over the long term. On his website, www.findingmoats.com, Dorsey lists four variables to determine the competitive advantage of a company: net margin, return on assets, financial leverage, and return on equity. Companies that have competitive advantages will have solid returns on capital that will get better over time.
One of the stocks in the Prime Time portfolio, Graco, Inc., has all the characteristics of a company with a competitive advantage: increasing net margins and excellent returns on capital, while not being too leveraged.
Graco, Inc. (NYSE:GGG)
Source: www.findingmoats.com
Conclusion
You don’t need a lot of information to make a decision on investing in a good company. Too much information doesn’t improve accuracy and instead can make you overconfident when you have no reason to be. There are times that additional information does contribute to more accuracy but the studies have shown that it will most probably decrease rather than increase your accuracy.
Follow Buffett on the amount of information you need to make a decision; in this case less is best. Getting a big overview of the company and not focusing on too many variables will make you a happier and wealthier investor.
Berkshire Hathaway Letter to Shareholders, 1989
Heuer Jr., Richards J., Psychology of Intelligence Analysis. Center for the Study of Intelligence, Central Intelligence Agency, 1999, p. 51.
Ibid. p. 56.
Berkshire Hathaway Letter to Shareholders, 1977.
Less is Best, on Graco, Inc.
Mae West, legendary movie star and sex symbol of the 1930s and 1940s, said that “too much of a good thing can be wonderful.” I’m sure that most people would agree. In fact, Warren Buffett used her quote when writing about taking meaningful positions in businesses that he has a long-term conviction for.
With so much information available about a company and its stock price, how much information do you really need in order to make a decision? Is too much information a wonderful thing when it comes to selecting stocks to buy? To be good investors, most people have the image of a bespectacled analyst sitting at his desk piled with financial statements and working way into the night. After many hours of crunching numbers in spreadsheets that are filled with complex formulas, our hardworking analyst has a eureka moment after plowing through scores of financial variables and finds that the company’s stock is trading at half the value of the underlying business. If that is your image too, after you read this month’s letter I’m sure you will change your views on how much data you really need in order to analyze a business.
Science or Storytelling
Although I wasn’t born in Missouri, the Show Me State, in this life, I must have been born there in a previous life. I need to see credible studies done in a scientific setting before I accept something as fact. It never ceases to amaze me how many people so readily would believe a story over scientific fact. I see that a lot in people who ingest huge amounts of nutritional supplements. Although most scientific studies have shown that supplements have no effect and sometimes can be harmful, these people still cling to their belief. In other words, they are willing to accept storytelling over science.
If you ask the average stock analysts how much information they need to evaluate a stock, I’m sure you will hear numbers that reach into the mid teens and higher. The Value Line Investment Survey has been published for over 70 years, and tracks 1,700 stocks. A Value Line stock page provides a wealth of information on a given company. The page has over 50 pieces of information. In the statistical array table alone there are 23 different pieces of historical financial data going back at least 10 years. Looking at the Value Line page for the first time can be very intimidating when trying to value a business. But have no fear, you don’t have to focus on all 50 pieces of information. In fact, studies have shown that more is truly less in this case.
Using experts in a variety of fields as test subjects, experimental psychologists have examined the relationship between the amount of information available to the experts, the accuracy of judgments they make based on this information, and the experts’ confidence in the accuracy of these judgments. They did the experiments by controlling the information they made available to the experts and they checked the accuracy of their judgments based on that information.
And They’re Off…
One such experiment was done on horse handicappers. Similar to stock investing, there is a myriad of past performance data on horses. For this experiment, they chose eight experienced horse handicappers and showed them a list of 88 variables found in publications like the Daily Racing Form. Data such as races won, speed ratings, weights carried, etc. are published on each horse. Out of the 88 variables, each handicapper was limited to using only five variables that they felt had the greatest importance to handicap a race. They were then asked to limit their selection to the most important 10, 20 and 40 variables.
After they selected their most important variables, they were then given true data (no way for them to identify the horse and the actual race) for 40 past races and asked to rank the top five horses in each race in order of expected win. Each handicapper predicted each race four times–using 5, 10, 20 and 40 variables. In order to measure the confidence of their selections, each handicapper was asked to assign a value to their prediction from 0 (not confident) to 100 (a sure thing).
The result of the handicappers’ predictions compared to the actual results was counterintuitive. The accuracy of the predictions remained the same regardless of how many variables they used. In other words their accuracy using 5 or 40 variables was more or less the same. However, as the number of variables used increased, so did the confidence level of their judgments. They had more confidence in their selections when they used 40 variables than when they used fewer variables, yet their accuracy remained the same. The more data they used to predict the outcome of a race, the more confident they felt about their selection.
The results were not isolated to horse handicappers. Similar tests were done on clinical psychologists asked to make judgments on subjects, medical doctors asked to diagnose patients, and stock market analysts asked to make long-term predictions on stocks. The conclusions were all the same; the accuracy of their predictions was similar regardless of variables, yet the more variables used the more confident they were about their predictions. The conclusion from these studies was an eye opener.
Experts overestimate the importance of factors that have only a minor impact on their judgment and underestimate the extent to which their decisions are based on a few major variables (editor-italics mine). [T]he analyst is typically unaware not only of which variables should have the greatest influence, but also which variables actually are having the greatest influence.
Buffett’s Four Filters
While researching these studies and reading the conclusions, it didn’t come as too much of a surprise to me. Over 30 years ago, Warren Buffett wrote that he only uses four variables when selecting a stock or a business for acquisition:
We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price.
What is notable is that over the past three decades, when asked the same question, Buffett has always been consistent about the four variables he uses. If a business or equity can pass through all four filters, Buffett takes a sizeable position.
The Moat
One of the variables that most investors have trouble identifying is finding a business with favorable long-term prospects. Buffett has spelled it out over the years and now refers to it as a business with an enduring competitive advantage, or moat. Patrick Dorsey, Morningstar’s director of research, recently came out with The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments (Wiley 2008). In it, he answers the question of how one can accurately identify companies that are great today and likely to remain great for many years to come.
By being able to identify a company’s competitive advantage and purchasing its shares at reasonable prices, one can build a portfolio of solid businesses that will be worth more over the long term. On his website, www.findingmoats.com, Dorsey lists four variables to determine the competitive advantage of a company: net margin, return on assets, financial leverage, and return on equity. Companies that have competitive advantages will have solid returns on capital that will get better over time.
One of the stocks in the Prime Time portfolio, Graco, Inc., has all the characteristics of a company with a competitive advantage: increasing net margins and excellent returns on capital, while not being too leveraged.
Graco, Inc. (NYSE:GGG)
Source: www.findingmoats.com
Conclusion
You don’t need a lot of information to make a decision on investing in a good company. Too much information doesn’t improve accuracy and instead can make you overconfident when you have no reason to be. There are times that additional information does contribute to more accuracy but the studies have shown that it will most probably decrease rather than increase your accuracy.
Follow Buffett on the amount of information you need to make a decision; in this case less is best. Getting a big overview of the company and not focusing on too many variables will make you a happier and wealthier investor.
Berkshire Hathaway Letter to Shareholders, 1989
Heuer Jr., Richards J., Psychology of Intelligence Analysis. Center for the Study of Intelligence, Central Intelligence Agency, 1999, p. 51.
Ibid. p. 56.
Berkshire Hathaway Letter to Shareholders, 1977.
