One of my favorite aphorisms is, “When everybody is thinking the same, nobody is really thinking!”
Sometimes I think value investors fall into this kind of a thinking trap, universally accepting a single-minded approach to a stock, an industry, or a market without fully thinking it through. For example, in the early 1980’s, I fully embraced a low P/E approach to investing after becoming a disciple of David Dreman’s approach described in his original book on Contrarian Investing.
I regard low P/E approaches as being generally sound in helping to keep you out of trouble. Unfortunately, when used too rigorously, such approaches also keep you out of a lot of higher growth, high ROIC kinds of businesses, as well. I can recall that at the time of Buffett’s initial investments in Coca Cola (NYSE:KO) many low P/E “value” investors thought that Buffett was losing his discipline in paying what seemed like a riotously expensive 13 times for it. At the time, Coke was considered a relatively dull business, especially when so many companies at the time were selling at 8 or 9 times its earnings.
Most of us as value investors tend to look down at most other methods of investing, ridiculing them as lacking rationality or being too emotion-driven. Lockstep adherence to a single dogma or doctrine can lead to peculiar self-justified beliefs that get reinforced by restricted focus on the behaviors or portfolios of others “drinking the same Kool-aid.” In short, many value investors simply become too imitative rather than exercise their own judgment.
James Surowiecki, author of The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations spends a lot of time discussing this phenomenon. There can be wise crowds as opposed to the “mob” that characterized the Internet or Real Estate bubbles. What characterizes the wise crowd? According to Surowieck it has the following characteristics:
I) Diversity of opinion
Each person should have private information, even if it's just an eccentric interpretation of the known facts.
People's opinions aren't determined by the opinions of those around them.
People are able to specialize and draw on local knowledge.
Some mechanism exists for turning private judgments into a collective decision.
It is important to note that a wise crowd consists of decentralized specialists drawn from differing diverse backgrounds that apply their independent thinking and localized knowledge to address the problem. Information drawn is not centralized, but rather each person gleans his own private information.
Michael Shermer of Scientific American refers to the intellectual attribution bias, where we consider our own actions as being rationally motivated, whereas we see those of others as more emotionally driven. Our commitment to a belief is attributed to a rational decision, and intellectual choice ("I'm for value investing because the long run statistics demonstrate that growing cash flow streams are ultimately recognized by the market."); whereas the other person's is attributed to need and emotion ("He's for technical analysis because he's a always followed the crowd, and doesn’t want to do the fundamental spadework.").
Be very wary of this thinking. There are many rational choices available which may or may not, agree with yours.
Surowiecki stresses the need for diversity within a crowd to ensure enough variance in approach, thought process, and private information. He warns of the dangers of the information cascade, a situation in which every subsequent actor, based on the observations of others, makes the same choice independent of his/her private signal. In an informational cascade, everyone is individually acting rationally.
Still, even if all participants as a collective have overwhelming information in favor of the correct action, each and every participant may take the wrong action. The tendency to rely on others to assess the information, and merely copy is, in my view, very strong among many investors. It is more efficient for everyone else to simply copy those around them.
The great investors have applied a mosaic of thought processes to come up with their conclusions. Charlie Munger is an intellectual jewel who relies on a vast and diverse knowledge base to support his investment thinking. Mohnish Pabrai incorporates such thinking in his portfolios and has written extensively about this in Mosaic: Perspectives on Investing and in Dhando Investor. Bill Miller of the renowned Legg Mason Value Trust has also described the importance of a diverse thinking process in his investment approach and exhibited it in spades with very non-traditional equity choices that are investments in his mutual fund. Much of this thinking is outlined in the Legg Mason Value Trust 25th anniversary review which is here (.pdf). I highly recommend reading this very useful but lengthy essay.
The unique approach that Miller utilized in embracing technology stocks at a time that most of us failed to consider them is outlined:
In late 1999, Bill spent a fair amount of time discussing the fundamentals of technology stocks and how we valued them. Many traditional value investors had chosen to ignore technology companies or to maintain minimal exposure to them despite long data trails and compelling evidence that the sector had the ability to create substantial, long-lasting shareholder wealth. Our research was based on the belief that although technology changes reasonably rapidly, it didn’t follow that such changes were random or unpredictable. And we believed, based on our analysis of financial services companies and health care companies, that technology companies often created change and instability in other unrelated businesses. Focusing our research in the area of technology and trying to understand the valuation of companies in that space led to considerably better performance for the Fund than if we had simply employed simplistic backward looking valuation methods.
In another 1999 letter to shareholders, Bill incorporated the work of William James from his essay “The Will to Believe.” Bill discussed James’s argument that in many cases one was justified in believing something well in advance of what others may consider sufficient evidence. The argument as it relates to owning a stock, in Bill’s view, is that the level of evidence one needs to believe something is a function of how important it is not to be wrong. The evidence bar will be set higher the more important it is not to make a mistake. If being right has a high value and being wrong a low value, then the evidence needed for belief can be a lot lower since being wrong is not very costly, and being right has a high payoff.
This parallels the probability weighted theory that Pabrai describes in Dhando Investors, well as the “decision-tree” description that Munger has used in marveling about Buffett’s thinking patterns.
On Sunday, we learned that the Buffett lunch auction was “won” (if $650 grand for a lunch is a win), by Pabrai, and another money manager, Guy Spier of Aquamarine Capital Management. Spier has the following link on his website, The Ignorance of Crowds. I think that those of us who try to develop investment talent at investment management firms can gain some valuable insights from this article.
It describes the Linux phenomenon of an open source development model. This level of collaboration works because,
it dramatically increases the speed with which problems, or bugs, is uncovered and fixed. When only a relatively small number of programmers work on a complex program, debugging consumes huge amounts of time and causes lots of delays — and many bugs still manage to sneak through. When you mobilize hundreds or thousands of people, however, they find and fix bugs much more quickly and thoroughly.
The power that a crowd of contributors has to solve problems derives not just from its sheer size, although that is important, but from its diversity. It’s only because the members of the crowd have, as the author put it, “differing agendas and approaches” that they’re so effective at finding so many bugs so quickly. If the participants shared similar outlooks, they’d all end up looking for the same things in the same places. What an unorganized, fairly random group of people provides is not just a lot of eyeballs but a lot of different ways of seeing. As University of Michigan professor Scott Page writes in his new book, The Difference: How the Power of Diversity Creates Better Groups, Firms, Schools, and Society (Princeton University Press, 2007), ‘When solving problems, diversity may matter as much as, or even more than, individual ability.’
But diversity does not imply egalitarianism.
The open source model — when it works effectively — is not as egalitarian or democratic as it is often made out to be. Linux has been successful not just because so many people have been involved, but because the crowd’s work has been filtered through a central authority who holds supreme power as a synthesizer and decision maker. As the Linux project has grown, Torvalds has gathered a hierarchy of talented software programmers around him to help manage the crowd and its contributions. It’s not a stretch to say that the Linux bureaucracy forms a cathedral that coordinates the work of the bazaar and molds it into a unified product.
Ideas can be drawn from a wise crowd where they can be openly debated and uncovered. Drawing such ideas from the masses will work provided you have independent inputs, and avoid the problem of information cascades where “nobody is really thinking.” The greatest breakthroughs will always begin with “one good idea in one person’s head,” and the greatest products will always reach perfection through the concerted efforts of a highly skilled team, a meritocracy that chooses the best contributions, synthesizes the best ideas and melds them together for a final investment decision.
Individual value investors should celebrate the diversity of the marketplace, there are, as Buffett describes, many ways to get to heaven. Don’t merely be imitative of some guru, or some approach. Find yourself; find your own independent thinking pattern. Think in terms of payoffs: What is the risk if I am completely and totally wrong? And conversely, what is the gain if I am correct. Don’t get too stewed by your own juices, by the intellectual pew in which most value investors seek comfort.
Look for flaws, look for opinions contrary to your own, and try to understand them, not merely dismiss them. Yours may not be the only rationally motivated opinion! In this way, your thinking will be shaped from a quilt of numerous thought patterns, a mosaic that is finally unified into an investment idea.
I describe what some may think is a very arduous process. Yet, it truly is not. It is a wondrous intellectual challenge, a puzzle that requires you to draw a piece from every philosophical exposure you have thought about in life. Avoid homogeneous thinking and lockstep imitation. Celebrate diversity!