A Lesson on Brutal Honesty

This article is part of our Rising Star Portfolios series.

The product of a Brooklyn and Staten Island upbringing, my father's an inveterate New Yorker. He doesn't pull any punches, routinely calls BS, and regards much of what he sees with a healthy sense of skepticism. I spent my adolescent years being disabused of the smug, characteristically teenage (and early to mid-20-something) sense that I'd figured the world out.

Sense of humility notwithstanding, my experience instilled a certain wisdom: I don't know a lot of things. But I thought I did, or was unwilling to admit otherwise. I wouldn't have known at the time, but that knowledge has proven instrumental to my investing philosophy. The markets are every bit as human as I was, or am: They err, making brutal honesty -- the sort my father offered -- necessary to successful investing.

Childhood, meet Mr. Market
I don't mean that as a slight. This isn't one of those pieces that rails against Mr. Market as stupid. I don't think the markets are stupid. They're quite a smart bunch, in my opinion, but that comes with a caveat.

During periods of uncommon psychological stress (say … adolescence), humans are bad at parsing information. Our bodies divert intellectual horsepower to survival activities (as detailed in Michael Mauboussin's More Than You Know, and that's an actual biological phenom, in case you're wondering). And investing is stressful. The logical extrapolation? We (people and market participants alike) assign meaning to events we don't understand, see meaning in the meaningless, and acknowledge (or ignore) information as it suits our worldview.

Our biology can make markets a minefield. Or a great opportunity.

Buy controversy
Recognizing this, I invest to take advantage of our eminently human tendencies -- situations where emotion, ego, and uncertainty intersect -- I buy controversy. Those are the stocks that the market is most apt to misprice, because they're the subject of stress.

It's a 5-year-old's logic: Difference of opinion, or controversy, means someone is wrong. Uncertainty fiddles with our logical senses, and companies' longer-term potential can end up mispriced. Great companies are sometimes valued as merely good, poor companies as if they're humming a death rattle, and so on.

What a New Yorker can teach us about investing
Recklessly buying controversial stocks is stupid. Dispassionate analysis is quite another. My investing approach emphasizes skepticism of myself and others. I (try to) keep myself honest (and even then, know I'm as fallible as anyone).

Besides the usual -- poring over Securities and Exchange Commission filings and industry data, relevant economic information, competitive research, and spreadsheet exercises (otherwise known as valuation) -- I've employed a simple mental checklist. It's at the root of what I -- quite affectionately -- refer to as the Ugly Portfolio, my Rising Star Portfolio.

1. Seek diversity of opinion: This idea borrows from one of my favorite investors, Bruce Berkowitz. Where most stock pickers start with a theory of the case, Berkowitz tries to "kill companies" -- parlance for deconstructing a thesis. And that's what I do.

The rationale for this process is simple. Positing something -- anything -- psychologically (and egotistically) anchors me to an idea. That starts the process of putting up blinders.

Instead, I start with a stock that looks cheap and try to prove myself wrong. I pore over any (and all) information, however inconsequential it may seem. That sounds simple enough. But in my experience, the root of many errors isn't stupidity, but some combination of ego, emotional attachment, and assigning meaning where there isn't any (which can be mistaken for stupidity).

That keeps me honest, which leads to point 2.

2. Don't get emotional: It's OK to cry at your wedding. But it's stupid to attach to Steve Jobs' black turtleneck, or the idea that he's a superlative leader. Even if Jobs is as good as posited, Apple (Nasdaq: AAPL  ) still might not make a successful investment from today forward. Besides, we really don't have any unique insight into Apple's inner-workings, as we sit eons removed.

It's not that I have anything against Apple, or Steve Jobs. I own an iPhone, and think he's a brilliant man.

But the very moment I like something in the warm fuzzy way -- an executive, a company, or anything about it -- my objectivity is compromised. I keep my head out of the lovefest. That might cost me some multibaggers, but it also prevents costly mistakes -- those that derive from hanging onto overvalued companies with "visionary" leaders and questionable moats, or worse, out and out capital wasters with a good shtick.

My rule of thumb: Buy businesses/valuations first and great leaders second.

3. Don't predict: 70% of people profess to be above average drivers (and coincidentally, that's a made-up stat). And that's the point: Philip Tetlock's seminal work, Expert Political Judgment, finds that people who profess to be experts are horrible at predicting. Moreover, they're horrendously overconfident. The takeaway: Knowledge is at once the friend and enemy of the successful investor -- it can prompt emphasis on the short term while missing the bigger picture, or just the opposite.

As I evaluate investments, I instead focus on the probabilities that an event will (or will not) pass. The question isn't really what a company's worth as implied by a spreadsheet with an arbitrary bunch of growth rates. Instead, I ask myself -- in light of prevailing economic conditions, a company's competitive position, and the means by which it can create additional value, am I paying a reasonable price?

In doing so, I create a degree of intellectual detachment. I'm not predicting the future, but examining the range of prospective outcomes. It's a subtle, but important way to reframe the analytical process.

Where the Ugly meet the money
It's this approach that led me to the Ugly Portfolio's first two purchases -- stocks I think that even the most grizzled, brutally honest New Yorker can get behind: RailAmerica (NYSE: RA  ) and Asbury Automotive Group (NYSE: ABG  ) . These companies face seemingly ugly headwinds, but on an assessment of their longer-term prospects, they look mighty cheap to me.

And I've been putting some of my Rising Star money to work behind them. So join me in my odyssey -- at my discussion board, in my article's comment feeds, and so on. We'll have a grand time.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Michael Olsen doesn't own any of the stocks in this article, insists he's never willfully killed a company, and loves New York for all its barbs. Apple is a Motley Fool Stock Advisor pick. The Fool owns shares of Apple, Asbury Automotive Group, and RailAmerica. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. 


Read/Post Comments (4) | Recommend This Article (29)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 14, 2011, at 2:00 PM, TMFAgewone wrote:

    You're only saying that because you work with me. But regardless, thank you.

  • Report this Comment On January 15, 2011, at 4:20 AM, blesto wrote:

    Your Dad's gotta be proud of you.

    I'm reminded of one of my favorite quotes by a great NFL coach of the Steelers, Chuck Noll. He would often say to reporters, "You think you know, but you don't know."

    Whenever I'm feeling ready to pull the trigger on an investment, that quote rings in my head and I try to dig a little deeper for info about any said investment.

  • Report this Comment On January 15, 2011, at 10:43 AM, MazonCreekRich wrote:

    Good article!

    The Dunning-Kruger effect is an experimentally observed inverse correlation between competence and confidence.

    Darwin knew of it: “Ignorance more frequently begets confidence than does knowledge."

    So did the great Irish poet Yeats:

    "The best lack all conviction, while the worst

    Are full of passionate intensity."

    So I worry when I encounter certainty – people who believe that gold is at all times and in all circumstances a good investment, people who have unblinking confidence in massive, multi-assumption valuation studies, etc.

    Confidence makes people blind to contrary facts.

    Of course, I am just guessing when I say that!

    Best,

    Rich

    BrokeInTheBurgh

  • Report this Comment On January 15, 2011, at 5:13 PM, DefunctAcct wrote:

    Darn, I wish the author had not spilled the beans. These are absolute essentials when investing. That said, I do have two nit picks.

    The author did not emphasize the importance of understanding a company and the products and the product strategy. Without such knowledge, neither objectivity nor caution are sufficient. Ignorance guarantees failure.

    Second, let us not get carried away by lofty philosophical terms and forget the practical. Investment, despite the most cautious and in-depth analysis, is not for those lacking conviction.

    I have to have conviction in my analysis and confidence in my approach and the data it generates before I could weather a downturn in order to emerge with even higher gains. I need such confidence to invest in a company (Apple) right when an overwhelming number of experts were openly calling for it to close its doors.

    Those lacking convictions and confidence would be selling whenever the market twitches.

    Other than these two nit picks, this article is very well done indeed.

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