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Managing Equity Portfolios – Go, No-Go – Making the Decision – Part 3

“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
– Benjamin Graham

We would be willing to hazard a guess that the vast majority of investment literature is focused on two primary topics: idea sourcing and investment analysis. As such, our pieces thus far have focused on diving more deeply into those specific stages of the investment process.

This week we want to spend some time walking through a critical part of the investment process that receives very little investor attention: the actual process of making the ‘go/no-go’ investment decision. This critical step is often taken for granted: once an investor identifies and analyzes a potential investment, the choice to put it into their portfolio is more or less a given.

Yet here we would interject with a note of caution, and just say ‘not so fast.’ In the course of building and refining our investment approach, we have spent a considerable amount of time reading and researching human decision making. The overwhelming finding from this reading is that while we all believe we are great at making decisions, in actuality, we are quite poor at it. We call this the Lake Wobegon effect – Lake Wobegon from Garrison Keillor’s A Prairie Home Companion is “where all the women are strong, all the men are good looking, and all the children are above average.”

Nobel Prize-winning psychologist Daniel Kahneman notes in his book Thinking Fast and Slow that heuristics, the rules of thumb we use in making decisions, are “quite useful, but sometimes lead to severe and systematic errors.” Kahneman goes on to postulate that the brain functions with ‘System 1’ and ‘System 2’ thinking. System 1 is our ‘fast thinking’ or the thinking that we do using expert levels of information we may possess in our domain of expertise and any relative heuristics we can apply. System 2 thinking is the slow, deliberate process that engages the full measure of one’s cognitive abilities.

There are three primary pitfalls which we believe investors face:
1. Maintaining Objectivity
2. Managing Complexity
3. Avoiding Error

Each of these pitfalls arises when System 1 thinking takes over and keeps us from fully evaluating the best possible decision. Below we address each pitfall, and what we believe to be the appropriate way to engage System 2 thinking (i.e., how to use our full cognitive abilities to make the best possible investment decision).

Maintaining Objectivity – Devil’s Advocate

“Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof”
– John Kenneth Galbraith

“When my information changes, I alter my conclusions. What do you do, sir?”
– John Maynard Keynes

Robert Cialdini in his seminal text, Influence: The Psychology of Persuasion, notes that “Once a stand is taken, there is a natural tendency to behave in way that is stubbornly consistent with the stand.” What he means is that after someone has given mental assent to a view, they naturally are going to behave in ways to reinforce that view.

Any married couple is no doubt aware that once one partner has stated an opinion (“I know which way we are going”) that it is extremely difficult to convince the other of the contrary position. Once the initial opinion has been expressed, the challenge is even stronger thanks to something known as Confirmation Bias. Confirmation Bias states that we naturally look for and assign greater importance to information that supports our thesis.

In investing, consistency with a proposition and confirmation bias can be toxic to investment outcomes. If we develop an investment thesis and then naturally only look for evidence to support its veracity, there is a significant danger of staying in bad investments too long, or worse, staying in them permanently as the business declines to zero.

Our solution to this dilemma is a Devil’s Advocate process. As Kahneman notes, “it is easier to recognize other people’s mistakes than our own.” We take that seriously in our process, as we dedicate 1 person entirely to working to disprove any proposed investment, i.e. what are the flaws in our assumptions? How could we be wrong? If, and only if, both parties agree – will an investment be made. Once an investment has been made, it remains contingent upon the Devil’s Advocate to continue his role and play the contrarian with regards to the on-going maintenance of the position.

Managing Complexity – Checklists

“Fools ignore complexity. Pragmatists suffer it. Some can avoid it. Geniuses remove it.”
– Alan Perlis

Noted surgeon and New Yorker author, Atul Gawande, has done a significant amount to advocate for increased use of checklists. What Gawande and others have found is that in a world that is marked by increased specialization and increased levels of complexity, there is simply too much of a cognitive load for someone to try and keep in working memory all the things that need to be done.

Gawande in his 2007 New Yorker article, The Checklist¸ tells the story of Peter Pronovost, a physician who has been working to see checklists deployed in medical facilities. In one facility, checklists deployed to maintain proper sanitation procedures in intensive care units saw infection rates fall 66% in only 3 months. In the first 18 months of the checklist program, $175MM in cost and 1,500 lives were saved.

Numbers such as that seem so large as to be almost misleading or potentially invalid – after all how can something as simple as a list of ‘do-this, then that’ drive such outcomes?

The reality of medical practice is that in the hustle of the hospital / clinical setting many things simply get omitted, such as hand washing. Moreover, in many cases, repetition dulls the mind and leads to an inability to recall if you have followed all the proper procedures.

Investing is really no different: businesses, industries, and economies are highly complex entities. With public companies, specifically, there are numerous potential risk factors that could lead to an unfavorable investment outcome that must all be taken into consideration.

So for example, an investor needs to understand how and why a customer purchases a given company’s product, how the internal operations of the company function, how much debt the company carries and its appropriateness, what the regulatory environment is like, etc.

For each potential investment there are numerous such questions that must be answered and well- understood to ensure that an appropriate assessment is made of the business. In our experience, there are simply too many things that need to be analyzed to keep them all in mind – which is the reason why we have created our Investment Checklist.

Developed over a 5 year period, our 150-point checklist is our best attempt to formally codify past successes and failures of ourselves and other investors into a central document. This document guides our analysis of an investment and gives our Devil’s Advocate a tool by which questions can be raised.

Avoiding Error – Write-ups / Re-Underwrites / Process Improvement

“Any man can make mistakes, but only an idiot persists in his error.”
– Marcus Tullius Cicero

The third and final pitfall we face as investors is error avoidance. Both maintaining objectivity via a Devil’s Advocate and managing complexity through Checklists are important components to avoiding error, but there are several other dimensions that are worth addressing.

Former Treasury Secretary and former Managing Partner of Goldman Sachs, Robert Rubin, noted “Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.”

What Rubin is discussing here is often best thought of as ‘process vs. outcome’ thinking. In many scenarios of life, people focus entirely on outcomes, such as ‘Did our team win or lose today?’ In an outcome based approach, when victory is attained, the feedback is to just continue to do the same thing and keep winning (“don’t fix what isn’t broken”). However, in a probabilistic environment such as investing, where many factors, including luck, can determine whether or not you are successful, determining why you were or were not successful is of the greatest importance, i.e., focus on the process and the outcomes will be better and more consistent.

In fact, our arguably greatest fear / concern is having an investment work out favorably, but not for the reasons we anticipated. In that scenario, we were equally as wrong as when we made a bad investment, but do not receive the painful reminder that comes with a bad investment.

So this leads us to our original question of how do we avoid errors. Sections 1 and 2 of this essay deal with ex ante error avoidance, the final section is regarding ex post error avoidance – how best do we handle errors after the fact.

To best address this question, an example from the world of software development may be of some assistance. When developing software, the programmer lays out a logical sequence of events. If a certain event happens, then the software should perform such and such action. Within the programming language that the programmer is using are some predefined ways to handle errors. These error handling tools instruct the software what to do when something unexpected occurs.

So for example, if the software is expecting a user to input a whole number (integer) and the user inputs a number with a decimal, the software knows immediately what to do. When that occurs, the software immediately executes a particular type of code that dissects the error and then can either resolve the error and continue operating or stop the program entirely. We have all see examples of poorly written error handling in the dreaded Windows ‘blue screen of death’ or the Mac ‘never-ending spinning beach ball’.

We think there is an elegant logic to how software manages and resolves errors by defining in advance how to handle such errors. We have tried to take that same methodology and adapt it to our own end.

First, every investment requires a thorough (20-30 pages long-form) written analysis which we call an ‘underwriting memo.’ Like the software above, the written analysis is the predefined ‘code’ for the investment. It specifies why the investment is attractive, specific catalysts to move the shares from the current price to our target price, and what the potential risk factors and associated mitigants are.

Second, we define at the outset an automatic re-underwrite point, a specific price at which we are required to update our analysis on the investment. This price specifies in advance a price decline that would make us question the validity of our original thesis. So for example if shares of J.P. Morgan fell from $60 to 50, we would be forced to take a step back and determine if something changed and if our thesis is still correct. The successful completion of a re-underwrite is a written document that provides a thorough updated analysis of the investment for the Devil’s advocate to critique further.

Finally, upon the completion of an investment, we conduct a post-mortem analysis. This analysis takes the original written thesis and compares the outcome achieved with our original thinking, i.e. were we right for the right reasons? This comparison provides the traceability to ensure that an investment was correct for the correct reasons. Where specific errors can be identified, this allows us to generate new checklist items and / or to further improve our investment write-up template.

Concluding Thoughts

The end result of these steps we believe to be an investment process that is self-reinforcing in nature. By using written analyses, pre-defined re-underwrite points, and post-mortems the investment process itself becomes iterative (i.e., it ‘learns’ and ‘grows’ over time) and we are able to improve over time by cultivating best practices from successful investments and learning from mistakes made.

Checklists and the Devil’s Advocate review help us to make sure that from the outset we are not letting things slip through the cracks (managing complexity) or not objectively analyzing each investment.

Compounding capital over time is demonstrably easier by avoiding losses in the first place. By focusing on process and continuous improvement thereof, the path to compounding capital is made easier over time.

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