The Emperor's New Clothes
If you’re at a cocktail party and there’s a naked man wandering about, but no one is paying attention to him, don’t assume they can’t see him.
I hear phrases like “this makes no sense” and “the market is crazy” quite frequently. Investors utter these phrases and at best, move on, while at worst, they take a position thinking that the market will come to its senses. I think it’s a bit intellectually lazy because it implies that the market should conform to your world view. And, if the market always did this, you’d never see mispricing and wouldn’t be able to outperform.
In markets, things don’t need to be rational, but they do need to make sense. I wrote about how Tesla’s valuation is divorced from fundamentals here. It’s not rational, but it makes sense when you consider order flows.
A way of thinking rather than a body of knowledge
I often think that one of the most useful things I did for my investing career is a biomedical science degree. I know this sounds ridiculous, because what could the citric acid cycle and cadaver dissection possibly have to do with financial markets? Although the latter is useful when disposing of underperforming analysts.
Science is often thought of as a body of knowledge but it’s much more a way of thinking. Scientists think differently. It starts in your first year of undergraduate study when you begin to critique journal articles and design and conduct your own experiments. At this point, you learn to pray you’re never reincarnated as a mouse or a frog. But you also start to see a lot of hypotheses proven wrong and many unexpected results.
Presented with an unexpected result, a scientist thinks “that’s interesting” or “I don’t understand” and investigates further. They don’t say “this makes no sense” because, frankly, biomedical systems don’t care whether or not you understand them, they’re going to keep doing what they do. This frame of mind helps in investing too: find out why things are the way they are and when they might change.
“What else explains this?”
Even if a hypothesis is proven correct, scientists don’t stop. They ask themselves: “what else explains this?” – indeed their peers ask the same questions, that’s what peer review is all about (and why debate at investment committees is so important). “What else explains this?” is a useful question to ask yourself before you take a position and after you’ve closed it. Let’s assume your thesis is “Vestas Wind Systems (VWS) is undervalued because the market price underestimates margin improvement potential. I believe margins should revert to 8% within the next 12 months, resulting in returns of 35 – 68%”. (That’s not investment advice, do your own work).
Okay, margins are one explanation, but what else explains the “undervaluation”?
Is VWS in fact fairly valued and you’re overestimating margin improvement potential?
Is VWS indeed undervalued, but management have missed earnings so many times (with negative price reactions) that no analyst will pitch it to their PM because it might be as career limiting a move as getting Bernie Madoff’s face within a love heat tattooed on your neck. This means it’s unlikely to be purchased in sufficient volume to make price and value converge.
And many other rational explanations…
Once you’ve closed a position, it helps your investment process if you ask yourself what else might explain the outcome. Let’s assume you earned a positive return and generated positive alpha. I hope the explanation is you’re such a weapons-grade analyst that UN weapons inspectors frequent your office, but it’s probably more complicated than that. Did one of their peers get bought-out which juiced sector-wide valuations? Did it get added to an index, resulting in passive investors pouring a metric shedload (not to be confused with the imperial shedload) of money into the stock - and then smugly touting the benefits of passive investing? Who is surprised if a stock rallies while you’re rapidly buying a meaningful percentage of their outstanding shares in a price insensitive manner? It’s like stepping into in a running shower and being surprised you get wet. I feel a tangent coming on, focus James.
Asking yourself “what else explains this?” is far better than “why might I be wrong?”. The latter inspires cognitive dissonance: no one likes to be wrong, so you’re not likely to explore as many alternative explanations as you might if you asked yourself “what else explains this?”. The former inspires curiosity and challenges you to find things that might not be initially apparent, making you more likely to find these alternative explanations and avoid landmines – or at least think more clearly about how things might play out. Furthermore, once you’ve considered a scenario, you can assign a probability to it, helping you calculate an expected value and take only those positions with positive expected values.
So to wrap it up, think like a scientist. Be curious and investigate things that look irrational. Ask yourself “what else explains this?” or “what would I need to believe for this to make sense?”. And mostly, if you’re at a cocktail party with a sartorially challenged, but largely ignored man, don’t think no one can see him. It might be that someone is trolling you.