Stock Analysis and the Illusion of Control

“The greatest obstacle to discovery is not ignorance – it is the illusion of knowledge.” ~ Daniel Boorstin

The Art of Thinking Clearly is a nice book from Rolf Dobelli. In one chapter, Dobelli shares a couple of instances…

Every day, shortly before nine o’clock, a man with a red hat stands in a square and begins to wave his cap around wildly. After five minutes he disappears. One day, a policeman comes up to him and asks: ‘What are you doing?’ ‘I’m keeping the giraffes away.’ ‘But there aren’t any giraffes here.’ ‘Well, I must be doing a good job, then.’

A friend with a broken leg was stuck in bed and asked me to pick up a lottery ticket for him. I went to the store, checked a few boxes, wrote his name on it and paid. As I handed him the copy of the ticket, he balked. ‘Why did you fill it out? I wanted to do that. I’m never going to win anything with your numbers!’ ‘Do you really think it affects the draw if you pick the numbers?’ I inquired. He looked at me blankly.

Consider my own example. I was once a die-hard cricket fan…or let me say I was a fan of only watching India win (and hated it when they lost).

So, during crunch matches, I used to change my seating places in front of the TV frequently to hit upon one from when India started doing well.

I got up from that place, and the Indians either lost a wicket or dropped a catch, so I stuck to that place throughout the crunch situation.

I thought my seating place controlled the fate of the Indian team, which was such a stupid thought.

I suffered from what is known as an “illusion of control”, which is basically the tendency to believe that we can influence something over which we have absolutely no sway.

Illusion of Control in Investing
Illusion of control is also seen in stock investing, when investors who do a lot of hard work before picking up stocks believe that their hard analysis and knowledge gives them control over the future of stocks they own.

On the other hand, there are many who do not start investing at all – or outsource the task to a broker or ‘trusted’ friend – because they see stock analysis as an enormous task.

“So many stocks and so less time to deeply understand businesses!” is a common refrain from people who avoid doing any independent analysis on stocks and invest or speculate largely based on tips they receive from others.

The mere thought of analyzing companies seems paralyzing, and thus people either defer their investment decision-making for years, or simply give up on doing it themselves.

Now the moot question here is…

How Much Analysis is Enough?
I have received a lot of emails over the past two years from readers asking a few of such questions –

• How much business understanding is enough before making an investment decision?”
• Can I invest in a stock without a perfect understanding of its business?

This is something even I wondered during the initial part of my investing career – “Do I need to have a perfect understanding of a business before considering buying its stock?”

Based on my experience and that of other successful investors around me who have bought stocks with “perfect” knowledge and also with “imperfect” knowledge, the answer is – No!

The reality is that, no matter how hard we try to analyze the intricacies of a business, we may not be as important to the results as we’d like to think we are.

Several investors spend too much time exposing themselves to all the informational noise that is distributed over the Internet in the hope of boosting confidence enough to be comfortable with our investment decisions.

But it’s important to understand, as a wise man said, that over the long-run you will probably do better building a portfolio of companies that make you uncomfortable (those you’ve bought with imperfect knowledge) than building a portfolio of companies that make you comfortable (those you’ve bought with perfect knowledge).

Your investment process should be focused simply on understanding and valuing businesses, and being better at it than other investors.

Trying to increase your confidence by gathering information that is supposedly unknown to most others really only makes you more comfortable with your investment decisions, not better at them, and is generally an unproductive use of your limited time.

Here is something Seth Klarman wrote in Margin of Safety…

Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them.

They study the industry and the competition, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer.

This diligence is admirable, but it has two shortcomings.

First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information.

Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit. This is not to say that fundamental analysis is not useful. It certainly is. But information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent.

Moreover, business information is highly perishable. Economic conditions change, industries are transformed, and business results are volatile. The effort to acquire current, let alone complete information is never-ending. Meanwhile, other market participants are also gathering and updating information, thereby diminishing any investor’s informational advantage.

…Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty.

The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

In short, even as the experts are busy focusing on such areas as “forensic” accounting, “channel checking,” public policy analysis, “lie detection” on conference calls, data mining and networking, you may do better by starting with imperfect knowledge, and cut out on the signal-to-noise ratio that has degraded substantially over the years.

Stop Trying Too Hard
James Montier of GMO writes…

The amount of information that assails us on a daily basis is truly staggering. Unfortunately, we tend to equate information with knowledge. Sadly the two are often very different beasts. We also tend to labour under the misapprehension that more information is the same as better information.

Experimental evidence suggests that often where information is concerned less is more!

In fact, numerous studies have shown that increasing information leads to increased overconfidence rather than increased accuracy.

And overconfidence, as you already know, is such a big killer of investment returns.

Use the “Less is More” Checklist
I believe rather than obsessing with the bewildering fusion of news and noise, you should concentrate on a few key elements in stock selection, i.e., what are the 5-10 most important things you should know about any business you are about to invest in?

Of course, if I knew the exact answer I would have retired long ago! 🙂

Even if I could know all the facts about an investment, I would not necessarily profit. This is not to say that fundamental analysis is not useful. It certainly is.

But information generally follows the well-known 80/20 rule: the first 80% of the available information is gathered in the first 20% of the time spent.

So if I were to list down eight questions that, I believe, would help me do an 80% analysis of a business, they would be…

1. Is the business simple to understand and run? (Complex businesses often face complexities difficult for its managers to get over)
2. Has the company grown its sales and EPS consistently over the past 5-10 years? (Consistency is more important than speed of growth)
3. Will the company be around and profitably better in 10 years? (Suggests continuity in demand for the company’s products/services)
4. How has the company performed on Buffett’s earnings retention test? (Checks if, over time, retained earnings deliver shareholders at least Rs 1 of market value for each Rs 1 retained)
5. Does the company have a sustainable competitive moat? (Pricing power, gross margins, lead over competitors, entry barriers for new players)
6. How good is the management given the hand it has been dealt? (Capital allocation, return on equity, corporate governance, performance against competition)
7. Does the company require consistent capex and working capital expenditure to grow its business? (Companies that have to spend continuously on such areas are like running on treadmills, which is not a good situation to have)
8. Does the company generate more cash than it consumes? (Cash generators have a higher probability of surviving and prospering during bad economic situations)

Get Over Your Illusion of Control
I would leave you with this beautiful little video from the 2008 movie Kung Fu Panda, where the wise old tortoise Master Oogway explains the illusion of control to its disciple Shifu, who is charged with training the unlikely Po, a giant panda, to become the next great kung fu Dragon Warrior.

The master says – “My friend, the panda will never fulfill his destiny, nor you yours until you let go of the illusion of control.”

If you can’t watch the video above, watch here.

Also, if you understand Hindi, here is a video from the epic Mahabharata, where Lord Krishna tells Arjuna how he has the right to perform his actions, but is not entitled to the fruits of the actions…and thus he must not let the fruit be the purpose of his actions (getting over the illusion of control over the results).

If you can’t watch the video above, watch here.

How often in our lives do we try to force an apple or an orange out of something whose essence is a peach?

Master Oogway and Lord Krishna remind us that we cannot become so attached to an outcome that we imagine it in our minds.

In stock investing, often we focus so much on trying too hard that either we never start working on the process of picking up great businesses (seeing the enormity of the task), or we start believing that our immense hard work and knowledge gives us great control over the future of stocks we own.

The reality is that, no matter how hard we try to analyze the intricacies of a business, we may not be as important to the results as we’d like to think we are.

It’s thus important to remember what Klarman wrote…

Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty.

The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

Feel lighter? 🙂

Afterthought: Here’s something beautiful I found just a while back, which goes well with today’s thought of “less is more”, and giving up the illusion of control.