A long time ago when I was trying to learn how to draw and paint (note: unless childlike stick figures become immensely popular I failed as a painter, which is why I picked up photography), I read a book called Drawing on the Right Side of the Brain by Betty Edwards. The idea of the book was to help a person tap on the strengths of the right side of the brain and "deepen your artistic perception" when engaging in creative endeavors. Athletes and musicians often talk about "being in the zone" and from personal experience as an investment analyst, a drummer, and a professional sports photographer, I can tell you I believe that you can put your brain in either a "right brain" or "left brain" thinking mode. One of the first exercises in Edward's book is to look at a picture and draw it. More than likely it will look "ok" but the perspective and other things may not look just right. The author then tells the reader to turn the picture upside down and draw it again. You would be amazed at how much closer to the original the second drawing looks than the first attempt. Why is that? Edwards explains that since the brain doesn't recognize the upside down drawing as an object, the brain switches to the right side and allows the artist to "see it" more in the abstract and not a preconceived recognizable image, which makes it easier to "draw" the lines more accurately. Since successful analysts incorporate the ability to think in non-linear, non-analytic ways; being able to tap into those aspects of the right side of the brain is very important. This idea can be thought of as "inversion."
"Man Muss Immer Umkehren" - Carl Gustav Jacob Jacobi
The idea of using inversion to solve problems is not a new one. Carl Jacobi was a German mathematician who lived in the early to mid-1800's. He believed that finding the solution for many difficult mathematical problems could be achieved if the problem was expressed in the inverse. For those who are curious, here is an example of one of those problems. Of course, most investors are more familiar with the English translation of the quote above, "invert, always invert" which was made famous by Charlie Munger.
It is no coincidence that these words of wisdom are often cited as "pure genius" and is an extremely valuable insight to being a successful investor. Munger suggests that investors use the same technique for breaking free from the left side of the brain thinking and into the more creative right side of the brain that Betty Edwards does, which is to turn the "image upside down." This type of thinking also helps investors, to borrow from Templeton Fund's advertising campaign, "see today what others see eventually." This idea is also similar to the concept of "second level thinking" discussed in Howard Marks' book, The Most Important Thing. (See our review of the book here and a comment on second level thinking.) When the idea comes from our own thought process, it is easier to put our brain into "right side mode" and focus our initial analysis in a more productive way. For example, if we are looking at potential investment ideas from a list of low price to book companies, then our focus most likely will start on the balance sheet. If we are starting with a list of low enterprise value to revenue companies, however, then we may start with historical margins or revenue growth rates. From the beginning, we have a process and are mentally focused on what we are trying to analyze and why. We also generally know what we should be looking for in terms of risks. However, when the idea is presented to us from an outside source (newsletter, investor conference, blog, etc.), we are more likely to just "see" it as it is, rather than in a more objective, "right-brained" way. It is much more difficult to have a conviction in an idea derived from an outside source as strong as one an investor analyzes from start to finish, no matter how thorough the original source's research was or appears. Each person's analytical process is different, so the conclusions made by one person are not always going to be the same as another's, even with the exact same information.
There are numerous websites and bloggers (Seeking Alpha, Valuewalk, Marketfolly, etc.) that aggregate and distribute investment presentations from most of the value investor conferences and from respected bloggers and authors. Activist shareholder filings (13Ds) and "guru" portfolios are carefully monitored and there are even mutual funds and ETFs that invest exclusively in these ideas. Judging by the media frenzy and stock price movements that surround the disclosure of an idea at one of these conferences, we feel that too many investors (professional and non-professional alike) are just "buying or selling the news" and are taking the investment recommendation at face value. After all, if (insert your favorite activist /hedge fund/blogger/columnist/mutual fund manager here) is willing to go public with their detailed analysis, they must believe in it and it must be a sure thing, right. We think increased access to investment ideas and information from the internet has actually weakened the quality of the analytical process used in making investment decisions. This may seem counter-intuitive, but we believe it to be true. We think that putting your thinking into "right-brain" mode will improve your analytical process and help separate great ideas from good or even bad ideas.
"When personal judgment is inoperative (or forbidden), men's first concern is not how to choose, but how to justify their choice." -Ayn Rand
So how would someone put their brain into "right-side" mode when they see an idea from other source? The first this you can do is to develop the opposing view and try and "kill" the idea. By doing this you are "inverting" the idea from the start. For example, if an investment thesis is premised on investors over estimating a liquidity risk event (in other words overly discounting the valuation of the company due to a default risk, which happened to many of non-financial companies in 2008-2009), the analyst should try and visualize what would actually cause a covenant violation or what the maturity dates are of the debt that could be trigger points and the company's options at that point. This puts the analyst in a mode to prove to himself that this is not a risk and not to just accept the opinion of another. After all, apparently there are a large number of investors that do believe it is a real risk otherwise the stock may not be priced where it is.
Question every part of the investment thesis from an idea that has come to you from an outside source. Reading the risk section and the footnotes of SEC filings is another great way to get into the "right-brain" mode. It takes you away from the bias of the analyst and puts things into analytical terms. Ironically, this brings you temporally out of "right-brain" mode so you can have a "clean-slate" when you start thinking about the investment thesis. You are outside looking in and have separated your initial connection with the idea.
Many years ago, my wife said something to me that has helped me tremendously when I am starting a research or any other project. She told me to "begin with the end in mind". In other words, by starting at the end and working your way back to the beginning, you are able to see many potential problems or obstacles you might not have thought of in the beginning. In 1989, a research paper entitled, Back to the Future: Temporal Perspective in the Explanation of Events was published in the Journal of Behavioral Decision Making. The results of the research showed that when participants were asked to provide "prospective hindsight" (imagining that an event has already happened) the ability to correctly identify the reasons for that outcome increased by 30%. Based at least in part on this research, The Harvard Business School has devised a method to help project teams identify risks of a project at the beginning of the analysis process. They termed the method "premortem". Gary Klein's article discussing the method can be found here. Other good articles can be found here, here and here. This is another great way to use right-brain thinking and inversion. The idea of doing a premortem is to analyze why a project or investment failed BEFORE the project or investment is even undertaken. This is different from simply asking the question, "what might go wrong?"
The great Daniel Kahneman says that the premortem has two main advantages:
"it overcomes the groupthink that affects many teams once a decision appears to have been made, and it unleashes the imagination of knowledgeable individuals in a much-needed direction....The suppression of doubt contributes to overconfidence in a group where only supporters of the decision have a voice. The main virtue of the premortem is that it legitimizes doubts. Furthermore, it encourages even supporters of the decision to search for possible threats that they had not considered earlier."
By approaching the investment idea from these "inverted" views, an investor has a better understanding of the merits and strengths and omissions of the original idea. It also allows the investor to rearrange the idea into his set of priorities for investing. For example, perhaps the original idea put more emphasis on revenue growth and less on free cash flow. But you may place a higher emphasis on the later. This will help the analyst become even more comfortable with the idea because it is now is structured more along the lines of their thinking process and it is easier to "own" the idea now. The analyst can then try and "kill" the idea or even better, do a premortem to think about what actually did "kill" the idea.
We have passed on many ideas that we have seen from others. Many times the idea is sound, will probably work out, but we just didn't feel a high enough conviction with the idea. In one case, we passed on it in spite of the fact that we were able to eliminate our initial biggest risk to the idea!!!! But using "right-brain" thinking we became less comfortable with what most investors take for granted as a "given" in the investment thesis. Not that we were right and the others were "wrong", we just chose to "take" that pitch. Perhaps in the long-run we will be "caught looking" and missed a great opportunity. But investing is a long season.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Investing 501 is a pair of analysts with over 60 years of professional investment experience. This article was written by Tim Heitman, one of our Founders. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.