Terrier's Value Investing Weekly: The Best Way To Analyze A Stock Is...

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Includes: DIA, QQQ, SPY
by: Terrier Investing

Summary

"Confirmation bias" can damage your investment returns.

By learning what it is and thinking about how we fall prey to it, we can make more objective decisions and achieve better investment results.

Professional investors use many different strategies to enhance their objectivity. I name a few.

Value Investing Weekly Table of Contents

Last Week's Column: The Best Investment Approach Is...

Nobody, and I mean nobody looks forward to the holidays with Aunt Ethel and Cousin Bruce. The political arguments seem to get more strident every single year. This time, unconfirmed reports have just hit the wire, linking the front-running Republican candidate to some very sordid goings-on involving a turkey that may have been stuffed in more ways than one. Aunt Ethel is shouting about the hypocrisy of the right-wing's "family values," while Cousin Bruce is equally loudly demanding to know when we abandoned the good ol' American concept of innocent-until-proven-guilty. China lies shattered on the floor, and Grandma's dining room wallpaper is irreparably stained with cranberry relish. It's no big loss - the relish was inedible and the wallpaper needed to be replaced a few decades ago anyway.

It's not until several hours later, when under the influence of a heavy dose of tryptophan and maybe a little of Grandma's eggnog, something odd clicks in your brain. Four years ago, this exact same argument played out in reverse. Rumors arose about the Democratic candidate receiving kickbacks from a white-shoe Wall Street firm, just six months after she surprisingly voted against her party and helped pass a key piece of deregulation allowing investment banks to sell opaque "triple-A" collateralized debt obligations to orphans and widows. At the time, Cousin Bruce was crowing about how free markets were being replaced by crony capitalism - while Aunt Ethel was repeating, verbatim, the former senator's incoherent explanation about promoting international trade relations.

This, of course, is a fictionalized story. But you readers are smart, you can see where I'm going with this. Isn't it odd how from 2000-2008 everything that went wrong in the world was Bush's fault according to hardcore Democrats, while the Republicans cogently argued that one man could not possibly be the source of all our ills? Yet on the other hand, from 2008 until now, everything that went wrong in the world has been Obama's fault, according to those same far-right Republicans, while Democrats are now the "voice of reason?"

It's OK to have strong political views, of course - I have them myself - but hopefully, you can set those aside and recognize the implicit contradictions in these stories, which I used because they highlight an important concept that investors should be aware of. Something called confirmation bias - simply put, this means that we pay attention to data that supports our existing beliefs and ignore data that contradicts our existing beliefs. This is one of many interrelated cognitive weaknesses that can conspire to short-circuit the objectivity of our decision-making process, and consequently lead to poor investment returns.

While we can never dispense of it entirely, understanding that confirmation bias exists - and how and why it works - is the best step we can take to resisting its influence.

Before reading any further, I would strongly recommend that you take this little test. Don't worry - it's quick and easy. You'll understand why I asked you to take it once you're done.

In My Opinion, That's A Fact!

If asked how they analyze stocks, most people would claim that they carefully review the data (qualitative or quantitative) that they find relevant, and after doing so, they form their opinion. In reality, science suggests the opposite: that people very quickly make snap judgments based on relatively limited data, and subsequently "seek out" data that confirms their initial hypothesis (while ignoring data that disconfirms it.)

If you took the test earlier that I recommended, you probably understand how this works. Most people, when they see those numbers, say something like "the pattern is that each number is double the previous one." (I actually thought the pattern was that it was a geometric series - I guess I'm special.) The average person will then input one or two additional sequences - in my case, 3, 9, 27, 4, 16, 64 - and when they find that their tested sequences match, they're "ready to solve the puzzle" - like it's Wheel of Fortune or something.

In truth, the rule you're trying to find is actually much simpler than people guess - each number has to be bigger than the last one. Yet people don't come to this conclusion because they "see" a pattern and then try to confirm it, without ever trying to disconfirm it. There's no shame in missing this - I missed it too. I was too eager to find the pattern (notice how they subtly prime you with the "problem solving" title for the quiz.)

In fact, the reason that I wanted you to take this quiz is because it forces you to accept that you, too, are subject to these biases. Most people can easily identify bias in other people - hey, look at those message board nuts thinking that penny stock is going to go up! - but many believe they're somehow immune from it. Perhaps you are - but that's statistically very, very unlikely.

While the exact mental mechanisms are beyond the scope of this column, the general idea is that our brains are hard-wired to function causally. Meaning that when provided with any given data, we try to find the pattern or create a story to make sense out of that data. This is not a bad thing - most things in the world are indeed caused by something, and studying causal relationships is what has allowed us to achieve pretty much everything in human history.

The Best Way To Analyze A Stock Is: Objectively

Causal thinking can backfire in investing and business because we can be too quick to extrapolate conclusions from a few data points. Psychologist Danny Kahneman has studied this extensively. This anecdote about why the counties with the highest incidence of a certain type of cancer share the same characteristics with the counties that have the lowest incidence is fascinating. (I've time-synced this for your convenience. Watch until 23:25.)

In the investing realm, here's a simple example of how this works: stock charts. When I look at a stock chart and it's up massively in the past three years, I automatically dislike it - because I feel like it's "run up already" and everyone knows about it, so I've missed my chance. (Conversely, many investors would get excited about a stock that's going up, and automatically think "hey, that's a great company!") On the other hand, I have a bit more of a natural tendency to get excited when I see a stock chart that looks ugly - "yes! there may be opportunity here." As long as you know this, you can control it - the key is to think about it.

A practical example of how I've implemented this technique is in the somewhat unique way in which I approach the "idea sourcing" process. Early on in my investing journey, I usually utilized valuation as my first filter for deciding whether to research a company or not. If it was trading at a low multiple, or if the stock had been beaten down, I would look at it - and if it was trading at a high multiple, or if the stock had run up, I wouldn't bother. What I found, over time, is that this approach led me to make suboptimal decisions.

There were other, more complex behavioral factors at play - such as "fear of missing out" and "activity bias" (which we'll discuss in later columns) - but for now, the simplified version is that when I went looking for ideas, I would inevitably find them - whether or not they were there to find. Since I was already "looking for ideas," and I already believed that "value stocks" were better than "growth stocks," I was mentally looking to confirm an existing hypothesis - leading me to be less objective in my analysis.

Over time, I evolved to a different process that I use now - instead of actively looking for ideas I view my job as just learning about companies that are interesting for whatever reason. I focus on trying to understand the business before I ever even think about the valuation, so as not to have any preconceived notions. Obviously, most businesses don't end up being at an attractive valuation - but if I like them, I put them on my list of things to follow, continue to research them over time, and wait patiently for them to reach a valuation where I'd feel comfortable buying. Rather than trying to develop an opinion all at once because I have to make a buy/sell decision, I can simply be a quiet observer a long time before I'm ever forced to make a decision.

Given my standards, it is likely - highly probable, in fact - that most of these stocks will never come into my sweet spot. That's fine because I always learn something that may be useful somewhere else. And I have a high degree of confidence that by enhancing my objectivity and forcing me to be slower to come to opinions, this process will allow me to make more effective and profitable investment decisions in the long run (even if it doesn't feel like that in the short run.

This is similar to why many professional investors, such as Guy Spier, actually refuse to listen to or read pitches from other investors - it implicitly and irrevocably colors their perception of the stock, preventing them from forming a truly independent opinion. (Spier discusses this extensively in his book. He went so far as to move across the ocean. Personally, I find that a bit extreme, but I understand the drive to escape the crowd-think of NYC.) I personally do find it quite valuable to read other investors' ideas - but I start by trying to disconfirm them rather than confirm them.

What Should You Do? A To-Do List

As always, when I cite examples, they're only to give you "color" and help you understand how I practically apply the high-level concepts I discuss. I'm not recommending my specific investment process to anyone. Here is what I do recommend, though:

  1. When you're analyzing a stock, if you find yourself forming an opinion quickly, ask yourself why you have that opinion - and how much data that opinion is really based on. Attempt to forestall opinion-forming until you really have a handle on what's going on.
  2. Write down a list of investment characteristics you have strong positive or negative feelings about, that might not be purely rational. (For example: as frequent readers are likely aware, I enjoy reading about entrepreneurs/owner-operators and studying companies with management that fits this bill. While I do believe there is objective reason to expect owner-operators to be more motivated than professional managers, I also know that I idealize "entrepreneur stories" and may thus be likely to let owner-operators get away with transgressions that I would take more seriously from professional managers.)
  3. When you are about to make an important decision, think through (or write down) a "postmortem." It's two years later and this has gone horribly wrong. Why? (this is a good example of "inversion," another topic we'll discuss later.)
  4. Come up with your own ideas and post them in the comments section - what are other approaches to minimize confirmation bias and promote objective analysis? There's one that starts with a "C" and ends with a "T," but I want someone who isn't me to name it...

Further Reading

"What made Charles Darwin an Effective Thinker?" and Charlie Munger's "The Work Required To Have An Opinion." Both of these are insightful pieces from Shane Parrish's excellent Farnam Street blog (which I will be referencing a lot). They're great reads on how both Darwin and Munger actively utilize the principle of trying to disconfirm what they think they know, and how that made them incredibly successful and wise.

Slightly longer form, but still relatively quick - The Halo Effect by Phil Rosenzweig is a useful counterpoint to Jim Collins and similar business "stories." I do find business stories and business books to be quite useful in many instances, but The Halo Effect clearly demonstrates how powerful the impact of confirmation bias can be. A company's doing well, and factors X, Y, and Z are why - then all of a sudden the company's not doing well, and factors X, Y, and Z are still why. Same data, different story.

If you want to get even deeper into the topic, Thinking Fast and Slow by Danny Kahneman is an excellent (if dense) book. I will note that philosophically, it's important not to take this too far or too literally - Kahneman doesn't really seem to believe we can save ourselves from our inbuilt biases, which I wholly disagree with. Frankly, just knowing your weaknesses is half the battle.


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Comment Of The Week:

While I loved Cory Cramer's comment about lessons learned from playing poker, my favorite last week was Mike Serebrennik's very thoughtful paragraph on being a specialist vs. a generalist was excellent.

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I both agree and disagree with Mike, and his comment inspired me to write a future column about the topic. Stay tuned!

As always, please leave a comment with thoughts/questions/ideas. Also, if you found this week's column useful, please share with those who would be interested in/benefit from these ideas. I'm a medium for interesting topics, not an oracle on a mountain - this column gets more valuable when smart and interesting people share their own perspectives and views.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.