Seeking Disconfirming Evidence in Investing Research

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Grahamites
Aug 16, 2015
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“And one of the great things to learn from Darwin is the value of extreme objectivity. He tried to disconfirm his ideas as soon as he got ’em. He quickly put down in his notebook anything that disconfirmed a much-loved idea. He especially sought out such things. Well, if you keep doing that over time, you get to be a perfectly marvelous thinker instead of one more klutz repeatedly demonstrating first-conclusion bias”

--

Charlie Munger (Trades, Portfolio)

Of all the mental models imparted by

Charlie Munger (Trades, Portfolio), seeking disconfirming evidence is probably one of the hardest ones to implement due to human ego. Our tendency to justify away disconfirming evidence and to simply deny the existence of disconfirming evidence is strong, which makes actively seeking disconfirming evidence almost against human nature. After being humbled many times, I’ve finally come to appreciate the extreme importance of disconfirming evidence.

Theoretically, implementing the disconfirming evidence mental model doesn’t sound that hard. All you need to do is to find evidences that don’t support a thesis. I’ve found out that seeking disconfirming evidences for the stocks invested by gurus listed on this forum is a very helpful exercise in terms of practicing your ability to think critically and find disconfirming evidence. For instance, when I was watching a video regarding

Kyle Bass (Trades, Portfolio)’s investment in General Motors, I came across the following comments from Bass:

“GM is worth $28 billion in enterprise value. They will do $16 billion in EBTDA value next year. They will do $6 billion in free cash flow. It is much leaner, with capacity utilization is in the 90s. Every metric you look at GM is doing great except the recall issue, which will be behind them in the next few months.”

Let’s start looking for evidence against the $6 billion free cash flow. All you need to do is a little bit of calculation yourself. In 2014, GM generated $10.1 billion GAAP operating cash flow, which included $1.6 billion recall-related cash payments. There is also $1.0 billion restructuring-related cash outlay. However, every year there is restructuring charge, which makes it recurring theme at GM. Therefore, I would consider it a normal part of business. Excluding recall-related cash payments only, GM generated $11.7 billion operating cash flow. GM has also hinted that no voluntary contribution to pension in the next few years. For 2014, GM contributed $1.3 billion cash. If we exclude this pension contribution from normal cash flow, GM’s adjusted operating cash flow comes up to $13 billion. Management has guided $9 billion capex in 2015. Simple subtraction shows that GM’s FCF is $4 billion, instead of $6 billion Mr. Bass claimed.

The fact that Mr. Bass’ numbers are vivid and available makes it very easy to accept them as they were presented by Mr. Bass. Conversely, because the information you need to calculate GM’s real free cash flow is not easily available, it is evidently harder for us to actually perform the calculation in order to validate Mr. Bass’ number. But $4 billion and $6 billion is a huge difference.

Many other renowned investors cited the massive return of capital from management team as a key thesis to invest in GM. Well, one day Mr. Buffett was asked about GM. While he did not directly disapprove the share buyback pressured by activist investors, he hinted that he did not think it was a good idea for GM’s management team to return huge amount of capital to shareholders given the nature of the business. This should raise a red flag if you are also making the case for GM based on the return of capital plan.

Once you’ve gone through this exercise a few times with someone else’s investment thesis, it’s time to use that detective skills on your own investment ideas. Or better yet, if you have trustworthy and highly intelligent friends in the investment field, you may give them some incentive so they can come up with disconfirming evidences against the main investment drivers of the companies you plan to invest in. I have personally found this very helpful.

Keep in mind that the goal is not to seek disconfirming evidence for everything. You only need to seek disconfirming evidences for the most important things – the main drivers of your thesis – the factors that actually move the needle. For instance, last year I wrote an article (link) on a premium Chinese spirit brand Kweichow Moutai (CN-600519). I sent out my thesis to a few friends. One of the disconfirming evidences I got was the capex level. Even though it was a good point, it was not material to the thesis. On the other hand, another disconfirming evidence I got was the declining pricing power and gross margin, which I took much more seriously than the capex issue.

I’m going to end this article with another great quote from

Charlie Munger (Trades, Portfolio):

"We all are learning, modifying, or destroying ideas all the time. Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side."

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