Snap. Make fast, decisive and good decisions when picking and analyzing stocks. Snap decisions. Isn't that what we all want?
But how? Ian Cassel's article on indecision really got me thinking about the role of decision making. I've also been coming across more articles and books on decision making and lo and behold, I see a copy of Blink: The Power of Thinking without Thinking on my shelf. My wife is a Malcolm Gladwell fan and loves to buy books, instead of reading them... Anyways.
If I call it gut reaction, you know what I'm talking about. It's similar but not exact. By calling it a gut reaction, it hides the fact that it's an area that can be improved. You could call it an instinct or intuition, and you're either born with it or not, but even instincts are learned and developed.
But gut reactions are really subconscious signals from the amount of data that you've accumulated throughout your life that comes out in different forms. You'll see how this all fits in because I'm going to show you specific examples that will help you with your decision making.
I'm sure you've experienced things where:
- You get an uncomfortable feeling just when you're about to sign a big deal
- Your hands get sweaty during a conversation
- When you see a no-brainer deal, it's like a light bulb literally lights up
- Or maybe your gut really does have a reaction
Are these natural tendencies? Yes, but it's also a result of having picked up signals and clues that you haven't realized. I'm going to use the term "snap decision" because it's the term used in Blink, and I prefer it much more.
The Power of Snap Decisions and Processing
There are some things that we just cannot verbalize or explain. Here's an example. Think of a person you love and try to verbalize what that person looks like. It's impossible. I would never be able to figure out who you are talking about.
"Shoulder length hair, small roundish nose, big round eyes, egg shape face."
That's my wife. You'll never find her in a crowd with that description, but in my mind, I have the power to easily create an image of her and pick out a scarf that will suit her, or imagine the expression on her face when she gets her favorite cup of coffee.
Being a value investor and too much of a fundamentalist, it's too easy for me to ignore this part of how I think and process information. There are too many times where I find myself forcing an explanation that really can't be explained. Or not selling a position when my gut is giving me signals, but because I'm unable to verbalize or explain it logically, I ignore it - and lose money.
Checklists Are NOT Fool Proof
To avoid mistakes and bad decisions, you'd think that checklists are the answer. But it's not.
I sound like a hypocrite because I've written a lot about checklists already. These four are the ones that get read the most on Old School Value:
- 15-point Phil Fisher checklist analysis
- My investment scorecard
- Package of checklists to download
- My old flowchart checklist viewed over 27k times
I strongly advocate using checklists, just not 100-page versions or ones that require you to write an essay. If a checklist takes you a whole day or more, you're drowning yourself with information or you're looking at the wrong things. A checklist will not make you a better decision maker. A checklist is there to prevent you from blowing yourself up.
Blink starts with a simple story of a museum who bought an ancient statue after months of due diligence. They brought in geological experts to verify that the marble the statue was made from came from the correct time period. Other scientists ran all sorts of tests to verify that it was in fact an original. They did some crazy in-depth due diligence. The museum finalized the deal, and it was a proud moment.
Until one day, an expert in statues and art comes to check out what the news was all about. In one glance, he was taken aback. He didn't know what it was, but he felt it looked too "fresh" for something that is supposed to be centuries old. He couldn't put his finger on it. Then, another expert comes by, and for some reason, she feels "disgusted" and starts to analyze the fingertips of the statue. Long story short, the statue was a fake.
Now, the question posed in the book is, how were these outside experts able to understand that the statue was a fake the minute they saw it? Why and how did the scientists and the museum curator miss the signs, that now look so obvious in hindsight? This brings it back to why I don't like looooong checklists.
Checklists are good to narrow down a basket of stocks or to use as a last line of defense. It's not a good idea to base your entire thesis on a checklist as it could easily box you in.
Focus on the Important Facts. Everything Else is Noise
The people that realized the statue was fake didn't have a 50-page lab test report to base their decision off. They recognized just one important area ("fresh" and the finger nails) to tell them everything they needed to know about the status of the statue. Instead of being knee deep in documents approving the test results, these people were able to come to a fast and decisive snap decision.
The problem nowadays is that we are literally flooded with information, and we think that more information and quick information is good. No. Focusing on the right information is all that's needed. When Bill Ackman hosts a four-hour call defending his position in Valeant Pharmaceuticals (NYSE:VRX), which can be summarized in five points - there's an issue.
He's drowning himself in data and doing what all those scientists did with the statue. The more information you have must mean you know more. Right? Well, the short seller Andrew Left is the perfect example of simply looking at the important facts (the fingernails) to smell something foul with Valeant.
The market is the verdict so far with Valeant down 67% YTD and -83% in one year. Knowing what to ignore is just as important.
Focusing on the Important Things with Apple
My decision to continue holding Apple (NASDAQ:AAPL) is still strong, and my thesis and reasoning is simple. With Apple, I don't bother with trying to keep up with the trend of tech and what it is doing with motion detection for TVs, cars, or the next-generation iPhone. I don't care how many pixels the camera has or what size screen it will be. What I see is a strong brand with a rabid fan base begging the company to take their cash anytime something new comes out.
The company milks profits, and its free cash flow generation and balance sheet are out of this world. The valuation is simple, and my advantage is time. There are literally hundreds of things I ignore, but these simple facts are my fingernails. If these things change, then the whole story changes, and it's time to sell. Until then, Apple is a position that I didn't need to think much about. Once it hit a nice entry price, I was all in.
On the flip side, haven't you missed out on some no-brainers because you were really slow to make a decision despite the fact that you may already know the sector well and have prior experience with the company?
How to Improve Your Snap Decisions
The first requirement is that you have to know what you don't like in a company. It makes the process so much easier. Everyone is different in what they like and don't like, but you have to know your own list.
I have a short list based on past money-losing mistakes that irks me.
- Excessively paid management - the IRS defines the term broadly as "suitable" salary, but is a $65m salary really comparable to the position or suitable? C'mon.
- Self serving management - it's all about it.
- Talks without walking the walk - promises don't translate to the financials.
- Significant related-party transactions - paying kids, cousins and grandma.
- Chinese companies - Sorry. Trust is hard to build back.
- Excessive short-term debt.
- Companies constantly raising money or diluting shares.
- Needlessly long financials and reports designed to confuse and hide info from investors.
I also have a list of things that I always like.
- Frugal management.
- Management that understands that the business is bigger than it is.
- Simple accounting.
- Strong brands that have real value - Circuit City isn't a brand.
- And examples of 10 of my favorite numbers I look at that provide an insane amount of insight into the business performance.
Throughout my investment journey, I've been subconsciously checking off things on these lists when identifying and finalizing my decisions.
When I focus on the areas that are important for me to be comfortable, it makes the hard work in making an investment - enjoyable. When I get away from this, it is a mental struggle, and I get frustrated and irritated because I'm all over the place and it feels like I'm going nowhere.
Instead of trying to know everything about a company or management from A to Z, my decisions are more accurate when I focus on the points above.
Create Your Decision-Making Base
Just like a cake where you have a base and then you build on top of it and decorate it, I've rebuilt my base to focus around Quality, Value and Growth.
By creating the Action Score, Quality Score, Value Score and Growth Score, I've streamlined my fundamental analysis process even further, and it's now become my four horsemen.
I identify Quality with:
- Piotroski Score
Value is based on:
Growth is scored with:
- TTM sales percentage change
- Five-year sales CAGR
- Gross profit to assets
Action Score is the best of Quality, Value and Growth.
What is your quality criteria?
What is your value criteria?
What is your growth criteria?
Try to keep each to three to five criteria. No more. Force yourself to focus on what is really important to you and what has worked and helped you.
Just because I've listed 10 of my favorite ratios, don't try to use it all. Just because you read about a new valuation method, don't treat it like a shiny new tool where you ignore everything else.
Take a look at the table below. I got this from Adib Motiwala, a friend and value focused money manager. It was in one of his letters from a few years back and explains the 2,000+ words in this article.
Analysis, Decision and Reasoning Table
By creating a very simple table like this, it immediately increases your ability to recognize what you like and dislike. Update something like this once a quarter and you'll be able to recognize the good from the bad. You don't need a 200-slide presentation to make your case. It's obvious.
With a table like above, instead of analysis paralysis, you are presented with a list of highly actionable stocks.
I shared a story about a new OSV member who took my list of the best Action Score stocks from early in the year when I gave it away for free. He noticed a company on the list that he had seen around town, understood it from his personal experience and invested in it.
He was able to leverage his subconscious knowledge, and with the supporting focused fundamental evidence from the Action Score list, made a decisive bet that he is enjoying right now.
Create an Industry Handbook and Use it Like a Map or Guide
One project that I haven't been able to finish is to create my own industry handbook. Investopedia has an industry analysis handbook which is a good start. You get an overview of the industry and what the important metrics are.
What you'll do is:
- List all the industries you are interested in. Fidelity has a good resource.
- For each industry, write down 3-5 of the key criteria and metrics that have to be analyzed.
- Use it to quickly check whether an investment qualifies to be looked at.
If you're looking at retail, then you want to see how same-store sales have been over the years whereas SSS is useless for an insurance company. You may dislike debt, but it's needed in capex-heavy companies like utilities and oil drillers. So it's important that you are using the correct ruler to measure with.
The scientists who analyzed the statue were using the wrong ruler.
The goal isn't to make fast decisions. The goal is to acknowledge that our decision making can clearly be improved systematically. Also that decisive actions can be taken with a limited amount of focused and relevant information. It's not something you have to be born with.
Sure, deliberate practice is required for this to become second nature. But remember that it's just as easy to make slow and bad decisions with a ton of data. Ask Valeant and Ackman.
To make good snap decisions, start thinking about using decision trees, decision tables, noise eliminating tools, industry analysis handbooks, and anything else that will feed you good and proper information and guide you to faster and accurate decisions.
I have basic systems in place that tell me which valuation method I should use for which stock. I use my Stock Analyzer to quickly decide which stocks are worth investigating and then running several "what if" scenarios to test my assumptions and theories.
I don't read news, I don't watch news, I don't listen to news because it's too hard for me to filter out the useful 10-20%. Once you start diving in, you'll realize there is a lot of strategic thinking that goes on without you realizing, and these are just some of the ways to strengthen your decision muscle and apply it to your investing.
Next book on my reading list? Thinking, Fast and Slow.
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. I have no business relationship with any company whose stock is mentioned in this article.