Thursday, May 18, 2006

Is too much knowledge a good thing? Part 2 4 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
Readers of my first article on the above topic ("Is too much knowledge a good thing?") would have noted my main point: that return is often proportional to risk taken, and more knowledgeable investors tend to be more risk-averse. Some have questioned me on the logic of this: that the more carefully the investor analyses and sifts out proper investment-potential stocks, the less he is likely to get good returns --- how can this be?

Well it does not sound logical, does it? Well, I believe the answer lies in two aspects: firstly, that an efficient market is created by a common understanding; and secondly, the problem of paralysis by analysis.

For the first point, consider the methods of Warren Buffett which have been well-publicised in books and seminars: everybody probably knows how he screens his stocks (strong business moat, good management, high return on equity, good "free cashflow", steady profit growth). With the exception of the first two, which requires a bit more judgment, the rest can probably be easily culled from previous years' accounting statements. But everybody can do this, and the irony is that if the guru is popular enough, the pricing of his "type of stocks" will be made so efficient that all the positive abovementioned factors would be factored into the price (at the margin by fund managers, usually). Perhaps I should rephrase: that a little knowledge is a dangerous thing; a critical mass of knowledge that might give the extra edge must involve exercising of strong and accurate judgment of intangible factors that might be subject to disagreement by various parties (eg. the business moat and management issues as mentioned above).

For the second point, I have already outlined it in my earlier article, but shall elaborate in more detail. When analysing quarterly or interim financials, it is not difficult to find certain issues that one might not be entirely satisfied with, and the number of issues is certain to rise in proportion with one's training with accounting. I think auditors would suffer from this the most :-) "High increase in receivables!"; "Aggressive depreciation policy!"; "Negative cashflow despite profits!"; "High number of options being handed out/Very high remuneration for executives!": all these might come into the consciousness of the knowledgeable investor who looks at the statements. If one does not exercise some contextual judgment (eg. high receivables not a concern if the customers are MNCs ie. low credit risk) and what I call "making exceptions to the rule", a lot of potentially good investments can easily be ruled out on the basis of "sound investment rules". For example, one must learn to make exceptions for certain high-PE companies that can perform (eg. Keppel), for cyclicals (not all are bad, don't shun them all), for companies that have had one or two profit-losing years (especially if all the directors are buying, for example). There are two ways the investor who recognises these risks can react: he can cast a mental block over those companies which worry him in one way or another and reject them compltely from his buy watchlist, or he can consider buying and then monitoring. It is all too easy and common to favour the first option. But so many investments which worry investors in one way or another have turned out to be the best: Raffles Lasalle (high PE, but just gets higher), China Sun (substantial shareholder & Temasek sold out early), NOL (made terrible losses in 2002).

I speak from experience because I have been through all these: rejecting certain stocks wholesale on the basis of certain investment rules, before realising that sometimes it is just an excuse for laziness to think deeper and to dig deep into past experience to make better judgment. I believe the abovementioned second way of dealing with recognised company risks is the correct way to go about things. One recognises the risks, but buys into the story of the stock, and monitors situation vigilantly after buying. There is an analogy particularly suitable for this method: the ideas of the hedgehog and the fox popularised by philosopher Isaiah Berlin, which he uses to describe two main classes of thinkers:

The hedgehog: "relate everything to a single central vision, one system, less or more coherent or articulate, in terms of which they understand, think and feel – a single, universal, organising principle in terms of which alone all that they are and say has significance"

The fox: "pursue many ends, often unrelated and even contradictory, connected, if at all, only in some de facto way, for some psychological or physiological cause, related to no moral or aesthetic principle; their thought is scattered or diffused, moving on many levels, seizing upon the essence of a vast variety of experiences and objects for what they are in themselves, without, consciously or unconsciously, seeking to fit them into, or exclude them from, any one unchanging, all-embracing, sometimes self-contradictory and incomplete, at times fanatical, unitary inner vision"

There is a simpler summary of the differences between the two: the fox knows many things, but the hedgehog knows one big thing.

If the investor can operate in such a way that before buying, he thinks like a hedgehog, along "big picture" lines with a single idea that he knows will capture the imagination, while subsequent to buying, change his mental framework to that of a fox, constantly probing, questioning and analysing, routinely searching for different viewpoints on the evolution of the industry in question ..... then he probably would be a very successful investor. "Big picture" ideas usually capture huge gains if envisioned right (eg. ethanol, VoIP, commodities, Sentosa property... know which stocks I'm talking about in relation to these?), while constant post-purchase monitoring along various newsfronts provide the best kind of risk management. Somebody (can't remember who) said that the mark of a first-class brain is the ability to entertain two conflicting viewpoints/ideas in one's head and function properly with them: the investor who can think like the hedgehog and the fox would fulfil this ideal.




Anonymous Anonymous said...

Although your essential thesis appears rationally unsound, I wonder from experience whether it isn't true. Just knowing a lot of facts about a company or industry is not enough; either some real in-depth knowledge (not possible for most of us) or judgment is key. For a real live example (despite its recent falls) - Celestial Nutrifoods. I did a lot of research into all sorts of things like potential competitors (proposed HK listing of giant state enterprise competitor based in Harbin unlike Celestial) which I didn't see anyone else find - so I didn't invest. But the key point of judgment was, the stock was cheap, it had a brand, and the potential from the new development was enormous (with local government funding it may be added benefiting Singaporean investors!)So an arguably correct view was (a) this is a gamble (but one couldn't lose more than 100% of one's investment), but (b) the probabilities favour at least adequate execution, in which case the price would rise by multiples (as it indeed did).

I am reminded of another investment of a similar nature which I forwent because in that case I did know the industry and came up with seventeen reasons not to invest. The stock promptly went up seven times in a year. Again the key point was judgment - in a worst case the stock would go under (not too likely as the business had public benefits and government would step in, although such deal may admittedly have been structured to exclude the shareholders benefiting) but on the other hand if a deal could be stitched up (as was in fact done) the stock was ludicrously undervalued. Was just incidentally reading Whitman's latest missives and he is buying debt of GM at a good rate because he considers that if it goes under the US Government will move heaven and earth to give at least some value to the shareholders, which will require his debt to be repaid in full.


5/22/2006 3:42 PM  
Blogger DanielXX said...

Hi Anonymous,
Exactly. We share the same understanding. I have mentioned before that I consider both low risk/high probability and high risk/low probability stocks for my portfolio, and that is exactly why: although the latter is safer and boasts features like good track record etc all these is typically priced in, and offers medium returns. One should look to stocks which have been badly misjudged by the market for the multi-baggers, even though these offer lower probabilities of success. And in singling out these stocks, the "fox and hedgehog" thinking and judgment is crucial.

Thanks for your detailed comments. Hope today was good for you.


5/23/2006 5:59 AM  
Anonymous Anonymous said...

6/13/2006 4:32 AM  

To much knowledge is a bad thing when it comes to investing.

12/11/2012 4:26 PM  

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