Beware of anecdotal evidence when investing…

There’s one thing I can’t stand when I hear an argument: Anecdotal evidence.

I think humans are inherently story tellers and perhaps a good story provides some comfort. To me, though, it is no different than someone saying, “well my Dad smoked a pack of cigarettes a day and he lived to be 90!” Ok, so is that actually good evidence for me to smoke? Or should I trust the troves of actual, scientific evidence that says I should not smoke? (yes, I know I just wrote an article about “sin” stock out-performance)

Equally, when I hear a stock pitch or reason for investment, I hate to hear anecdotal evidence as a real justification. Here are some examples:

  • Media: I just cut the cord and hear all my friends are too. Cable companies like Comcast are going to face pressure
  • Transportation: I hear millennials are all about traveling compared to buying new products. I am buying airline stocks that will benefit from this.
  • Healthcare: My grandma needs a lot of medical attention. As the baby boomer wave hits retirement, the amount spent on healthcare is undeniable going up.
  • Retail: I only shop at Amazon now. All other retail / distribution is essentially un-investable.
  • New Technology: I read an article on how this [new technology] was able to do [something in a novel way]. There’s going to be a paradigm shift in the way we do things.

I think this type of investing is popular for a few reasons. For one, it is easy. You can just identify something you know and think of a company that will benefit from a trend. Second, Peter Lynch often wrote in his books that his children would talk about something they liked, he bought the stock, and it ended up being a 5-bagger or something.

I do think it is extremely important to be aware of trends, but this sort of investing has led to a lot of trouble. You also have to know “what is priced in”. For example, look at the return of Comcast since cord cutting really starting about 10 years ago — it is up 300%+ compared to the S&P return of ~170%. Sure Netflix is up more, but do you think many people analyzed whether or not growth in other Comcast businesses would offset the traditional cable model? Or that this was a lower margin business so therefore it didn’t impact earnings as much as one would expect? Also think about how much people complain about Comcast… yet it still prints a lot of money. That is a testament to its business model!

On the flip side of that negative outlook, look at something in the technology sector like 3D printing. It used to be all the rage where people would discuss how the industry would change the world after they saw it in action. However, that would have been a disastrous long-term investment decision, as shown below:

3D Printing stocks

These types of situations often allow a contrarian investor to profit. All asset prices reflect people’s expectations of future growth. By analyzing what investor expectations are compared to the price today, we can see whether an investment makes sense and is particularly undervalues. That’s often why in my model I run a “worst case” scenario for industries in which people believe are in secular decline as well as a “what do you need to believe” in the case of booming, hot technology stocks.

As a value investor, I like to invest in stocks where the expectations are really low. I’m critical of using earnings and the P/E ratio for valuing a business (I prefer FCF), but for simplicity, let’s look at this example. If you value a business on 1) current steady state part of the business and 2) the future growth of the business.  For number 1, we should assign a multiple equal to the cost of equity. If that cost is 10%, that is a 10x multiple. If I buy the business for 10x and those earnings are sustainable, then any future earnings are complete upside for me. If I can pay a low multiple then for a company that has a history of value creation, then I can get the business for value + the upside for free.

I think I should also mention one other thing: a secular declining business can last a lot longer than people think, but it has to have the right capital structure. For example, the yellow pages are still around! And the business actually throws off a lot of cash because the managers don’t need to reinvest in the business. However, YP has also been overlevered in the past, which has led to cases of bankruptcy. If someone had acquired the business for cheap, ran it with conservative leverage, then it might have been an attractive equity return.

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