Epistemology in investments
Dear investors,
Brazil has a culture steeped in empiricism. Here, it's said that "in practice, theory is different." Conceptual knowledge is given little value and tricks—the quick and easy way to achieve a goal, even without an explanation of how and why they work—are highly valued. Consequently, experience is valued more than erudition, because the more time dedicated to an activity, the greater the repertoire of tricks and practical examples accumulated in memory.
There's nothing wrong with practical knowledge developed through direct experience. Nothing brings more certainty than direct testimony, but the empirical method is the slowest and most arduous way to accumulate knowledge. Without the deduction of general principles that can serve as a basis for deducing applications in different cases, our potential for action would be drastically reduced. It would be like trying to memorize the results of various sums instead of learning the fundamental logic that can be used to add any number.
It's likely that almost no one would disagree with this. Still, most people abandon theoretical studies as soon as they move away from academia and embrace empiricism from then on. Even in intellectually sophisticated activities, this culture is visible in many practitioners. In investing, there are clear signs.
The extreme example is the hopeful day trader, who believes that if they spend enough time watching minute-by-minute price movements and memorizing a few dozen chart patterns collected by other traders, they will develop the ability to recognize signals that predict future price movements, and this will be enough to generate consistent returns. Another common, and less obvious, case is the investor who spends their days trying to stay informed about everything that's happening in the last few hours, hoping that by following every news report and informing themselves of every fact and rumor, they will have the best conditions to position themselves in the market. As with practical experience, being up-to-date on the latest news has its value, but focusing exclusively on this activity is inefficient and ineffective for an investor. Our approach is quite different.
The problem of empiricism
The greatest difficulty in projecting a company's results isn't understanding a specific dynamic involved in its business. Financial mathematics is trivial, and commercial relationships between two parties are typically straightforward. What adds complexity to the analysis is that businesses are open systems subject to a very large set of variables. Some are known and easily measurable, others are difficult to identify and quantify. The interconnection of these multiple, simple relationships ultimately forms quite complex systems with behaviors that are difficult to predict. The investor's challenge is how to analyze such systems.
Recalling a similar case from memory and assuming the same thing will happen is the instinctive approach, but it carries a huge margin of error, as it's virtually impossible to identify two business situations that are sufficiently comparable for the results to be replicated. Companies, competitive environments, and market contexts differ from case to case, so analogies often fall short. Identifying what exactly makes a business successful is a long-held dream, but attempts to create a quick and easy method for this purpose have never yielded good results. A famous example is the book Built to Last (Jim Collins, 1994), which selected companies with extraordinary performance in the decades prior to its publication and sought to identify what made them such good and sustainable businesses. In the following decade, about half of them went through periods of decline, invalidating the predictive power of what the book describes.
We are deeply skeptical of any simple method for estimating a business's future, as companies are too complicated entities to be described by a few measurable variables. Meanwhile, many investors evaluate companies by averaging valuation multiples of "comparable businesses," a method that seems useful only for illustrative examples and for detecting extreme distortions. What, then, would be a better approach?
Analysis by first principles
Any analysis begins by breaking down the system under evaluation into simpler components until logical and repeatable relationships between variables become evident. The description of the dynamics involved in these recurring patterns is what we call first principles: general abstractions that, while ignoring many details, allow us to predict the general behavior of a wide variety of similar situations.
A classic example of first principles is Newton's Laws of Motion, which allow us to predict the motion of bodies in space. Although predictions made from them are never completely accurate due to the interference of factors such as friction, a novice engineer familiar with them will be able to predict the motions of a mechanical system more accurately than an experienced engineer who lacks theoretical knowledge and has never seen a very similar system in action.
In business, we'll never have predictions as accurate as those made from the laws of physics, but the logic of first principles still applies in some situations. We know that the law of supply and demand will mean that a water stand at a tourist spot in the middle of the desert will be able to charge a very high price if it's the only one with water available. We also know that a very high price isn't sustainable over a long period unless there's something to prevent other water stands from popping up in the same location, as unusually high returns always attract competition.
The advantage of these simple and obvious inferences is that they are much more reliable than overly broad inferences, such as those in the book Built to Last, which identifies audacious goal setting and a strong institutional culture as factors for success. Many companies with strong cultures and audacious goals will fail miserably, but the monopolistic water stand in the desert will certainly pay dearly.
There are few general laws applicable to business that are stable over time, but there are still principles valid for specific sectors or periods that can be useful in investment analysis. As the world evolves, some of these become obsolete and others emerge. Identifying a principle that is still little known is invaluable, as it increases the chance of identifying price asymmetries not yet perceived by the market.
Our goal is to develop mastery of as many first principles as possible that can help us in our investment analysis. The best way to broaden our repertoire is to study, so we dedicate a lot of time to reading and seek out more diverse content than the bibliography typically covered by market professionals. We also seek to derive general principles from our direct experience, but this is a last resort, as learning through explanations from those who have done it before is an easier and faster way to absorb knowledge. This is the real trick.
The importance of focus
The world is big, and life is limited. Even with the most efficient learning methods, there's a balance between breadth and depth of knowledge. Investors who want to know all the companies they can invest in condemn themselves to knowing little about them and increase the risk of overlooking some aspect that could frustrate their expectations. In theory, this problem could be solved with a large team of analysts covering specific groups of companies. Several fund managers adopt this strategy, but we're skeptical about the possibility of forming a large group of excellent investors willing to collaborate and create a single, coherent portfolio. We understand that quality decisions come from a mind that gathers all the relevant information, and that having a few highly dedicated and qualified people is better than large teams, as the intelligence and wisdom of individuals don't add up when they come together.
It's impossible to know everything in detail, but there's an expectation that professional managers stay well-informed about all publicly traded companies. Just as laypeople believe doctors should know how to solve any health problem, many managers seek to meet this expectation with a technique that's efficient from a commercial perspective but offers little help in investing. They memorize concrete facts and figures that convey the impression of detailed knowledge. It's as if someone were asked if someone knows this man, and the answer were: "Yes, of course I do. He's 48 years old, 5'9" tall, weighs 180 pounds, has short gray hair, arrives at work every day at 8:15, runs in Ibirapuera Park, and likes lasagna." The data collection appears to be the result of continuous routine monitoring, but it may simply be a generalization of a single day's observation and is of little use in judging anything relevant about the person. The market equivalent is memorizing the figures from the last quarter's financial statements, the names of all the directors, and other miscellaneous information.
We prefer to pick our battles and delve deeper into a limited number of businesses, with the primary concern of not letting risks go unnoticed, as the cost of a bad investment is very high. It's the same logic used with health problems: it's best to consult a medical specialist, as the consequences of a mistake can be serious. In everything we don't dedicate ourselves to understanding thoroughly, we merely admit our ignorance, which brings us to the next topic.
Intellectual honesty
The biggest mistakes are made not by conscious ignorance, but by trusting a mistaken opinion, which leads to performing a harmful act with conviction. In investing, we deal with subjective analyses and incomplete information, so certainty is very rare. Arrogance (or naiveté) can cause severe losses, so it's best to be completely realistic about the mastery you've developed on each topic studied. While it's almost an act of common sense, the culture of the financial market is quite different.
In the market, admitting ignorance on a point is seen almost as a sign of incompetence. Young analysts are trained to always respond assertively, even if the answer includes estimates and speculations formulated on the spot. The person asking the question doesn't know the correct answer to judge them. Sometimes, the question isn't even particularly pertinent. They imagine it's better to convey an impression of confidence than to appear unprepared in front of someone. The problem is that we are shaped by our habits, and it's undesirable to incorporate this type of behavior in investment analysts.
Human nature already carries the tendency to exaggerate one's own abilities to preserve one's ego. An example of this behavior was formally mapped in 1981, when psychologist Ola Svenson conducted a survey in which 931% of American drivers considered themselves better than average drivers. Being truly sensible requires active effort and a certain methodological rigor. In other words, intellectual honesty is a habit that needs to be cultivated.
How to put good principles into practice
Knowing the method is often much easier than executing it. What needs to be done to reach the summit of a mountain is obvious: walk or climb until you get there. We believe that a good investor should complement their direct experience by developing academic knowledge and theoretical mastery of the broadest possible repertoire of first principles that can be leveraged in investment analysis, with the awareness that it is necessary to focus on strategically selected topics to achieve adequate depth.
This method doesn't yield quick results. We believe that only continuous dedication throughout life makes us increasingly better investors, as is the case in most professions. We also believe it's necessary to maintain good intellectual habits in our personal lives, as it's impossible to compartmentalize our conscience. Those who are disciplined and rational at work will be disciplined and rational on weekends, and, likewise, those who have vices in their private lives will carry those bad behaviors into their professional lives.
At first glance, this may seem like a rigorous approach, but it's a blessing that the same skills we need to cultivate to generate good returns on investments also serve to make our private lives peaceful and orderly, and vice versa. We believe that the practices we describe here have no contraindications, regardless of each person's primary function.
