a strange story involving the business cycle and being wrong

I once had a young colleague with lots of potential, whom I liked very much and who was an excellent securities analyst  …but who had only limited stock market success despite loads of potential.

Ass an apprentice portfolio manager, this person came to me with the idea of building a significant position in a company that made carpets.  The firm was well run, apparently had sustainable earnings growth momentum and was trading at a low price earnings multiple.   In this instance, I didn’t do my job as a supervisor well, more or less rubber-stamped the idea and okayed the purchase.

Soon after that (this was 1993), the Fed began to raise interest rates.  This is something I had been anticipating but–maybe because this wasn’t crucial to the structure of my own portfolio–was information I failed to bring to bear on the carpet company idea.  Higher interest rates slow down both residential and commercial construction, something which is bad for, among other things, sales of carpets.  Replacement demand slows down, too.

I went to my colleague, explained the situation–including the source of my mistake, and urged selling the stock.  We did, with a modest loss.  The issue ended up losing almost two-thirds of its value in subsequent months.

Now the weird part.

Eight years or so later, my colleague came into my office to rehash this trade–which I had long since forgotten.  The point was not to suggest that we buy the stock again–which would have been a fabulous idea, since business cycle conditions were finally very favorable.  Instead, it was to say that my colleague had in fact been 100% correct in recommending the stock all those years ago (apparently the stock has finally reached the point where its cumulative performance matched that of the S&P 500.

I didn’t know what to say.  This was somewhat akin to my aunt Agnes explaining that she was switching from natural gas to oil because the gas burner in the basement was really a malevolent space alien.

Why am I recalling this strange story–much less writing about it–now?

Two reasons:

–we’re coming very close to another period of Fed-induced interest rate hikes.  This is bad of early business cycle companies, including housing, commercial construction and related industries in the US, and

–it’s a life lesson about investing.  My former colleague had extreme difficulty in recognizing an analysis was wrong or that a stock, for whatever reason, wasn’t working.  But portfolio investors in the stock market are always acting on very imperfect information.  And economic conditions, both overall and in inter-firm competition, are changing all the time.  So having what one thinks is a better analysis than the other guy simply isn’t enough to ensure success.   Recognizing when things aren’t going well, stepping back to regroup and seeking out possible sources of mistakes are all crucial, too.  Denial may salve the ego, but it makes us poorer, not richer.

 

confirmation bias

what it is

Confirmation bias is the idea that you analyze something, form an opinion—and then spend the rest of your time searching for data that support your initial conclusion.  Anything that doesn’t confirm your opinion, you simply ignore or attribute little significance to.

To some extent, everyone does this. And in many situations in life, you can argue that everyone should. What if Michael Jordan had accepted the fact he wasn’t good enough to play high school basketball?

But it’s one of the worst faults an equity investor can have.

I can see three reasons it’s so bad:

–it takes a long time to become thoroughly acquainted with a company you invest in. My experience is that it takes at least a year of watching management at work—and maybe a lot longer–to figure out whether they’re any good at running a company and whether their strategy makes any sense.

In practical terms, almost no one is going to wait twelve months after getting an idea before taking a position. This is especially true if the stock price is already starting to move up as more people discover the company’s possible profit potential.  So professionals always make provisional “buy” decisions.

For a considerable portion of a stock’s life in a professional’s portfolio, then, it’s more or less on probation, subject to being kicked to the curb if a deeper inspection of the company proves the initial impression to be wrong.

That never happens if the investor spends no time looking for leaks in the boat, or refuses to acknowledge they’re there as the vessel beings to list.

–the world changes. Markets become saturated. New competitors emerge. Old competitors improve their game. The business cycle advances from recession to recovery to expansion—and then back to recession.

In addition, stock prices change, both in absolute terms and for one industry group vs. another. …one stock vs. another within the same industry, too.

–companies change. Managements become more—or less—responsive to alterations in the competitive environment. Great companies reinvent themselves as the environment changes; merely good ones often don’t.

APPL, for example, was a failing personal computer hardware company. Then it became the iPod company. Then it became the iPhone company…

NOK was once an obscure, failing Finnish conglomerate. Then it was the world’s leading cellphone firm. Now it’s a mess…

where the problem arises

It’s unusual to see a working professional suffering from terminal confirmation bias. Normally, anyone infected is quickly fired. In places where office politics counts for a lot they may be kicked upstairs—not a great move for the organization’s long-term health. But it solves the short-term problem.

For private individuals, I think this phenomenon surfaces mostly as lack of awareness of how smart the market is—a naïve belief that after a brief perusal they understand more about a company than the people they’re trading with.

Professionals face a different issue. Your analysis says the stock should be going up. It’s going down instead. When do you concede that the market knows more than you—either about the company, the environment or the stock valuation?  No one wants to be scared out of a stock by adverse price action.  On the other hand, no one wants to be caught looking only for information that supports his position, either.

what to do?

Many professionals use mechanical rules.  For example, if a stock underperforms the index by, say, 15% (or some other fixed number), at least part of the position is sold–maybe the whole thing.

Others. like me, don’t like fixed rules and depend on aggressively seeking out negative information about the positions they own, instead.

In well-run organizations, the Chief Investment Officer plays a role here, creating an atmosphere where portfolio managers feel able to sell losers, as well as limiting the size of iffy holdings where he/she sees the question of what to do with an underperformer is likely to arise.

individuals in this situation?

Thinking about a 15% rule before buying anything would be my advice.