When Investing, Scepticism is Your Best Friend

The most elegant investment ideas may turn to dust if you put them through a reality check

Published: Jun 24, 2010 06:00:59 AM IST
Updated: Jun 24, 2010 01:13:02 PM IST

During one of my visits to Edinburgh as a stockbroker with UBS Warburg, a canny Scottish fund manager greeted me by saying, “stockbrokers live to sell dreams”. Though I was livid with rage at his condescending attitude then, may I  now add that the sequel should be “they deliver nightmares”. Barring a few truly exceptional investors, most of us fall prey to the siren songs of our broker. Why does this grisly sequence recur so often?

Conventional wisdom has it that expert investors systematically gather all relevant data, then assess and evaluate the evidence in a highly rational manner and finally arrive at an optimal decision. The reality of decision making in practice is a long way off. While there is tremendous emphasis on putting together the “facts”, the method of doing so is often biased to suit a pre-conceived belief! At this stage, most of us choose to weave a narrative that suitably explains the evidence that has been gathered and discard all inconvenient inputs. This story then serves as the basis of “rational” decision-making. Psychologists label this model explanation-based decision-making and based on experimental results have found that it is much in vogue among lawyers, doctors, senior managers and not surprisingly, journalists.

The tendency among investors to frame their universe in terms of stories rather than well-documented, statistically valid relationships is what leads to serious trouble. For instance, investors are wedded to the notion that there is a strong positive causal relationship between high real GDP growth rates (read China!) and stock market returns. Study after study has demonstrated that nothing could be further from the truth and, if at all, there is a relationship it is mildly inverted. This seemingly “odd” finding is directly linked to the habit of investors consistently opting to overpay for future growth. In fact, without exception, the markets offering the highest returns were the ones that traded at the cheapest valuations at the point of entry. Can one argue with the idea that the price you pay makes a difference to your final return? Seems most investment professionals do.

Quite often it comes down to a fairly simple choice: “Must I believe this?” as opposed to the far less onerous “Can I believe this?” Given that the burden of proof is far higher for the first question rather than the second, investors need to learn to ask the first one consistently. The best value investors unfailingly deploy scepticism as their default option. The problem with scepticism, however, is much like common sense — individuals possessing it are truly rare — since our brain is wired to believe rather than doubt! All that lesser mortals such as us can hope to do is to confront our most strongly held beliefs with empirical reality. To illustrate, rather than accepting that a company is destined to grow revenues and earnings at 25 percent for the next five years and maintain its current return on capital employed of 30 percent, it is better to examine the facts by looking at the distribution of such an outcome over a large sample of firms for the last 15 years, broken into rolling five year periods and learn what history tells us! Turning into an empirical sceptic is the only way to survive the guiles of the brokers and information over-load. 

The problem with empirical reality checks is the destruction they wreak on the most conceptually elegant investment ideas! Only a solitary company — Swaraj Engines (Rs. 319) — emerged unscathed from my recent tryst with empiricism. The company is truly a diamond in the rough – compounded annual revenue and earning growth in excess of 15 percent for the last decade, average return on capital employed in excess of 35 percent during the same period and a pristine balance with zero debt trading at a trailing PER of 10! The evidence is certainly adequate to dispel what little scepticism I possess.

Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author, a partner at Fortuna Capital, frequently invests in the shares discussed by him.


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(This story appears in the 02 July, 2010 issue of Forbes India. You can buy our tablet version from Magzter.com. To visit our Archives, click here.)

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