The Science of Investing and a Framework to Build On
At Old School Value, we make it a point to learn as much as possible from others.
There is only so much that you can learn on your own and through your own experiences. By reading thoughts, mistakes and lessons from others, it is a shortcut to the whole learning process.
Just how much of a shortcut?
There are literally thousands of small fund managers in and outside of the US that I’ve never heard of who are achieving outstanding results. If you read Beyond Proxy you would know. Beyond Proxy does one of the best jobs in profiling excellent fund managers.
Recently, from Beyond Proxy, this post got me thinking about the science of investing. Stock valuation may be an art, but investing is still very scientific.
Take a look at the definition of “scientific method”.
The scientific method is the process by which scientists, collectively and over time, endeavor to construct an accurate (that is, reliable, consistent and non-arbitrary) representation of the world.
Here are the important parts to this definition.
- collectively and over time – you can’t be an expert with just a few trades under your belt
- reliable – use reliable and proven methods
- consistent – maintain consistency in your approach but be willing to change if something is wrong
- and non-arbitrary – eliminate impulsive decisions
The Basics of How to Apply a Scientific Method
Now here are the basic steps to apply a scientific method to anything.
Step 1: Come up with a hypothesis. Why might this be interesting? What do you think is going on?
Step 2: Figure out the important questions. Instead of trying to dive right into the solution, you need to ask more questions to better understand the problem you are trying to solve.
Step 3: Start answering the questions. In investing this is the equivalent to active reading of annual reports and the proxies for hidden pieces of information.
It’s going out and getting the information, both qualitative and quantitative information.
Also includes analyzing the financial statements, interviewing people in the industry, reading broadly and even watching a documentary.
Step 4: Analyze the data and test the hypothesis. With the data and knowledge that has been accumulated, it is vital that the conclusion is based on what the data tells you. Not to fit the data into a preconceived hypothesis
A Skeleton Example with Expedia (EXPE)
After a 20% drop on weaker earnings and guidance, the main fear was that competition was driving down profits.
Was Expedia losing ground or was this a temporary set back?
The Important Questions
- What type of growth and trend is the industry experiencing?
- Which competitor is threatening Expedia the most?
- Which area is Expedia seeing a slowdown?
- What is happening to its moat?
- Is the business healthy enough to be able to survive a short term hit?
Answering the Questions
- Read management’s report on the industry and business
- Read and analyze the competitor reports and what they are saying and compare
- Listen to the conference calls and look for differences
- Get a feel for the business by using a few websites and calling to see how the business operates and how consumers are treated
- Go through the financials
Make the Investment Decision
Expedia is a case where it took just one quarter to recover. With the growth of the internet, more people travelling, younger travelers spending more on hotels and flights, Expedia and the entire internet booking industry is seeking extraordinary and organic growth.
Companies like Expedia and Priceline have huge network effect moats and there are upcoming sites, but with names like Expedia, Orbitz and Priceline firmly entrenched, it’s difficult for new sites to gain ground.
Distinguishing Bias from Science
Another topic I want to touch is on pattern recognition.
Pattern recognition is one bias that needs to be avoided to become a better investor.
In investing, it seems like there are lots of similar patterns, but the truth is, companies and businesses are so complex that while a certain situation may seem similar on the surface, it can be completely different.
Look at how J.C. Penney (JCP) turned out for Bill Ackman. He was familiar with retail and Target (TGT) and Borders and thought he could make J.C. Penney work out this time.
Going after an investment based on a similar pattern can turn out to be a deadly mistake.
It can cause you to become overconfident and also, by believing that you know how something will turn out, you could end up oversimplifying, glossing over the details and missing key information.
This opinion post by Chris Dixon on pattern recognition and the scientific method resonates with me:
The classic scientific method provides a better model for investing. Scientists observe data, notice patterns, develop hypotheses, and then test those hypotheses. Pattern recognition is only a step along the way to developing hypotheses about the underlying cause.
After you have read this and look at a stock, remember this idea of taking a scientific approach to analyzing and investing in stocks.
This is just a framework. It’s there for you to enhance and make it work for you.
Actually, are you able to give an elevator pitch for your framework?
If so, let me know in the comments to this post. If not, you better get working on one.