Is it possible for an investor to examine a company, see deteriorating fundamentals, but not really "see" what's going on?
Sure it is. We did it last year with Cisco (Nasdaq: CSCO). I'll talk about Cisco in a bit. For now, let me explain what I mean by seeing and not seeing.
Psychologists at Harvard and other universities have conducted studies to learn more about how people see things and how seeing relates to human perception. What they learned may surprise you. Malcolm Gladwell, a reporter at New Yorker magazine, wrote about the findings in a story called "Wrong Turn," which appeared in the June 11 issue.
Essentially, psychologists discovered that distracted people don't see very well. For example, in one test, drivers talking on cell phones missed twice as many traffic lights and responded more slowly to those they did see than other drivers. Arien Mack, a psychologist, calls this phenomenon inattentional blindness: It's easy to miss something right in front of you if you've got your mind on something else.
All of this may not seem too surprising. In fact, it sounds like common sense, but as you'll see it has far-reaching effects. The article also included a story about Marc Green, a psychologist with a consulting company in Toronto. Green looked into an accident involving a woman who hit a cyclist.
Every morning the woman had the same routine: She pulled into a gas station at 5:00 a.m., fueled up, looked left, and pulled out. One morning she followed the same routine only this time she hit a man on a bicycle coming from the left. How could this have happened? How could she have hit the man -- how could she have not seen him coming -- since she did in fact look left?
That's where Green comes in. His explanation: "She'd looked down that sidewalk nearly every day for a year and never seen anybody. She adaptively learned to ignore what was on that sidewalk because it was useless information."
In other words, her brain told her the rider wasn't there, only he was, in plain sight, coming right for her. It's pretty scary. It reminds me of the lesson Edgar Allan Poe taught us more than 100 years ago in his "Purloined Letter," a story in which police miss clues laid right before them simply because they expected the evidence to be well hidden. It turns out the evidence was well hidden -- in plain sight.
What does this have to do with investing, the Rule Maker, or Cisco? For a year we watched Cisco's working capital management deteriorate as inventory levels grew. We saw this happening. Phil Weiss wrote a story about it in March. At the time, Cisco's Foolish Flow Ratio, our version of working capital management, had climbed to 1.28, up from 1.00 a year earlier.
Phil found that receivables had grown nearly twice as fast as sales, and inventory had grown more than four times as fast. As a rule of thumb, we like to see receivables and inventory growing at about the same rate as sales so we could see there was a problem. The company's flow ratio had grown steadily, in quarter after quarter, and Cisco ended up, as we all know, writing off more than $2 billion in inventory.
So how could we have missed it? Well, we didn't. Phil wrote about it, I wrote about it, Matt Richey wrote about it. We all saw the numbers. Still, since we didn't act on the information, we hit the bike rider, just like that motorist who looked but didn't see.
Can we blame our miscue on inattentional blindness? Well, I don't want to overstate things. In a sense, this sounds like a fancy way to cover a mistake. I don't want to dig too far into psychology or look for more complicated reasons than I need to explain our failure to act.
It's also worth pointing out that ratios aren't everything. Stocks go up and down, inventory and receivables fluctuate with business conditions. I don't want to start second-guessing every holding every quarter based on a couple of ratios. When we see changes in a company's ratios it should be a signal to look deeper, to look for the business reasons behind the change, not to react hastily based on potentially superficial changes. There are times when less information is better than more.
For me, however, I can say that Cisco had been so strong for so long that it was easy to look past the warning signs. I looked left and didn't see the rider coming. Considering the company's value at the time, this was an error, one I don't want to make again. To support the kind of market value Cisco had, its numbers had to be pristine -- and they weren't. We should have known the sidewalk wasn't empty since our own Rule Maker instrumentation was flashing, whether we saw it or not. We could have pared back our holdings and saved a few bucks.
If you believe investing is about learning to make better decisions, then inattentional blindness is a behavior worth knowing about, one that may help put future decisions into a new perspective.
Have a great day.
Rich McCaffery, co-manager of the Rule Maker Portfolio, hasn't been seen riding his bike since reading Gladwell's article. The Motley Fool is investors writing for investors.
