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.
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
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
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.
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