Book of Value: Generating and Sorting Investment Ideas

To make good investment decisions, we must do two things well: We need to generate ideas and we need to sort those ideas by their merits “to form correct impressions of reality.”

That’s the position and those are the words of Anurag Sharma in chapter eight of “Book of Value: The Fine Art of Investing Wisely.” It’s a book in which the author is developing a theory of investing that includes behavioral finance principles.

Throughout the chapter, he looks at the inherent tension between letting our minds run loose and disciplining them to avoid mistakes. As he summed it up, “Our mental machinery is powerful but prone to serious error.”

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Sharma's solution for avoiding serious errors is to follow general principles that allow investors to develop ideas and patterns that are credible and can be tested (as discussed in chapter seven).” data-reactid=”21″>Sharma’s solution for avoiding serious errors is to follow general principles that allow investors to develop ideas and patterns that are credible and can be tested (as discussed in chapter seven).

• Conceptual context: To stop the mind from wandering among limitless possibilities, he suggests that investors establish a context or theme, which would provide boundaries.
• Mental orientation: Our thoughts should be channeled toward “high-potential pathways,” which means focusing our attention and energy on the most promising opportunities.
• Data and patterns: Because our minds are apt to find patterns that really don’t exist, we need “a sophisticated sensitivity to data and an affinity for fact checking.” We should search for deep patterns; finding them is what distinguishes great investors from the rest of us.
• Major and minor theses: He was referring to the process of developing several minor theses within the broader context of a major thesis. One such major, or macro, idea is a shift in supply and demand; minor ideas within that context include opportunities that occurred when oil prices crashed in 2014.

In reading this chapter, it seems that Sharma is focused mainly on a top-down approach to finding investment ideas. A top-down strategy involves the study of broad economic or social trends, and how to profit from changes in the trends.

It’s an approach that has more appeal to hedge fund managers than to individual investors. As you can imagine, following, understanding and acting on broad economic or social shifts is a big job in itself. And once you’ve found what you think is a promising avenue for exploration, you still need to study sectors and individual companies within it.

For individual investors, without a staff of experts to watch and interpret the trends, a bottom-up approach is more practical. That involves analyzing individual stocks, doing fundamental analyses of measures such as earnings per share and cash flow.

A bottom-up approach will also involve some consideration of macro trends, but to a lesser extent. Consider the case of traditional retail versus online retail. If you consider investing in a company like Macy’s (NYSE:M), Walmart (NYSE:WMT) or Costco (NASDAQ:COST), you will also want to look at the broad shift to online shopping and therefore study Amazon.com (NASDAQ:AMZN) at the same time.

Moving on to chapter nine of “Book of Value: The Fine Art of Investing Wisely,” Sharma wrote that the path from ignorance to wisdom is often long and hard. However, investors can end up in the right place by learning the correct analytical skills and developing the right mindsets.

As he pointed out, people often begin their investing journey with “wild, frenzied buying and selling.” They chase popular names and give their attention to commentators, alternating between hope and fear while jumping in and out of positions.

As they become more experienced, they become more careful but still are relatively unfocused and still hoping for quick wins. That’s because they haven’t yet found a systematic approach. Finally, as they mature, they learn that investing involves more than just sharp buying and selling–it also means “making sound positional plays.”

While falsification or negation of investment ideas will lead to better results, it’s not enough. Mature investors also need to know the kinds of errors that they may make, regardless of how well they do their analysis. Broadly speaking, there are two types of errors:

• Type I: This refers to a false-positive, which means you suffered a monetary loss because you did not disconfirm the thesis that this was a good investment. Sharma provides the examples of Enron, Lehman Brothers and AIG (AIG).
• Type II: In this case, he is referring to a false-negative, meaning that you disconfirmed a good investment thesis and missed out on an opportunity. Examples include not buying Home Depot (HD) and Microsoft (NASDAQ:MSFT) in their early years.

Adding salt to the wound, Sharma advised that these two types of errors are exact opposites, and therefore any attempt to reduce a Type I error increases the odds of making a Type II error, and vice versa. However, if you know which type of error you would most want to avoid, you can reduce the pain somewhat.

And, as the author also observed, having a framework for these trade-offs means you “bring a measure of control to investment decisions.” You can control what type of investor you will become:

• A defensive investor is one who is willing to accept Type II errors (lost opportunities) and wants to avoid Type I errors (lost money).
• An aggressive investor is one who accepts the potential of Type I errors and wants to avoid Type II errors.

From a value investor’s perspective, I find this type of error distinction useful. By definition, value investing means avoiding monetary losses by insisting on margins of safety. We try to buy stocks at a discount because we know we may make valuation errors. This defensive approach also plays into the tactic of making money by not losing money.

Thus, being a value investor is being a defensive investor. We are prepared to give a pass to next year’s huge success in exchange for not losing cash now on ill-advised speculation.

From another perspective, think of the thousands of micro- and small-cap stocks that might be the next Apple (NASDAQ:AAPL) or Amazon.com. By making a significant commitment to one of them now, we might enjoy a windfall return at some time in the future. However, for everyone who makes the leap, hundreds or thousands of others will be mediocre investments at best or go bankrupt at worst.