Process versus Results

For this instalment of my rambling thoughts on investing I’d like to start with an enlightening anecdote taken from Michael Lewis’ book “Moneyball”. In said title, one of the main characters relates the following story:

“I’m playing Blackjack in Las Vegas, a guy immediately to my right, sitting on a seventeen, asks for a hit. Everyone at the table stops, and even the dealer asks if he is sure. The player nods yes, and the dealer, of course, produces a four. What did the dealer say? “Nice hit.””

Nothing odd in that story you may be saying, after all, the player won big and the house lost, right? Outcome wise, there‘s nothing to contest as the results are evident enough. However, process wise, the approach of the blackjack player was unduly risky and fundamentally wrong.
This simple example of human nature at work draws attention to one of the most powerful concepts in investing: process versus outcome.

All too often, market participants (notice I choose my words carefully to avoid labelling all those that buy and sell securities as “investors”) dwell solely on outcomes without consideration of process. This behaviour is nonetheless quite understandable. Outcomes or results are for one self-evident and constitute simple references on which to evaluate performance. In western societies the relevance of results, be they in academic, professional or even sporting events can hardly be understated.

Well intentioned investors however, are remarkably prone to establish a causal and two-way relationship linking positive outcomes to good processes, as in the case of our daring blackjack player walking away from the table reminiscing of his excellent playing skills…. By the same token, bad outcomes are more likely than not to be interpreted as the result of a poor process. These long-held “truths” are in fact not so at all.

Investing is its most narrow definition is a probabilistic exercise and as such it shares a key trait with other such endeavours like competitive sports-team management and non-random games such as chess. All of these fields emphasize process over outcome. In simple terms a good outcome with a bad process can only de interpreted as “luck” while a good outcome following a good process should be correctly though of as statistically likely.

Investing greats concern themselves first and foremost with process. Any serious investor is quick to acknowledge that random walks are a key feature of short-term market performance. As such they plan for the long term where a sound process constitutes the cornerstone of investing policy. At times of (temporary) market dislocation, it is their well-honed and honest investing process that hey can take comfort in.

The old saying of “keeping your head when all around you are losing theirs” is tantamount to investing success. If not, just witness the 10% yield Mr Buffet is getting form GE and Goldman Sachs in exchanging for providing cash at just the right time in the not so distant depths of despair bear market of 2008. The question is, if you had Mr Buffet’s cash-hoard would you have put it to work with GE as its stock dropped precipitously and simultaneously lost its coveted AAA credit rating?

Whilst I can’t claim that I would have done the same as Mr Buffet and held a steady hand in the middle of the “perfect storm”, there’s something that I can do and that I am willing to share here right now. It is my own stock selection process for the UF Portfolio. It has two redeeming features: it is simple and yet painstaking.

Perhaps that’s the beauty.

Below is a schematic description of my process:

1. Source investing ideas: Screening for Low P/E, P/B EV/EBIT, Low debt, mature exchange
2. Read-10 years of 10K / 10Q : Identify normalised earnings, asset values
3. Read MD&A Section: Look for execution ability, consistency and foresight
4. Check for aligned interest: Insider ownership, other value investors, changes in ownership
5. Review competitive landscape: understand sector, key players, brand or scale advantages
6. Perform valuation: Set a range/target price based on Assets, Earnings power, market transactions

7. If the outcome of steps 1 to 6 is satisfactory AND current price is 35% below value then INVEST

Not everyone would be willing to go to into this much trouble just to select a stock.

After all, you can always just go on a message board , base your stock selection decisions on a perfect stranger's "gut feeling" and hope for the best.

However if you do strike it lucky (unlikely as that is), please don’t boast about your prowess and acknowledge the role of lady luck!