10 000 hour rule debunked again

This 5-minute article suggests a few simple but powerful mental tools for getting more out of life and investment research efforts, avoiding waste and suboptimization


 

Some become world champions in just 1 000 hours, some never

First you must realize, there is no spoon 10 000 hour rule

there is no 10 000 hour rule

Please e-mail me at mikael.syding@gmail.com if you don’t recognize the picture

The 10 000 hour rule was debunked a long time ago, specifically when Donald Thomas, who commenced high-jumping in 2006, won the world championship in Osaka just a year later in 2007 (clearing 2.35m), without proper high-jumping shoes. The first time he ever tried high-jumping, on a bet, in January 2006, he cleared 2.13m in ordinary tennis shoes.

Actually, the 10 000 hour rule was a deliberate misinterpretation of data. The original research only showed the following:

  • if you have the genes
  • and the ambition
  • you may become a master in your area of expertise
  • if you practice between 3 000 and 30 000 hours
  • and then there are outliers, like Donald, who shows you could train even less, given a certain set of genes

i.e. a completely meaningless and useless result.

the Donald Sprezzaturian retarded hf manager

The Donald

 

Don’t be that guy throwing the 10k hour rule around as if it meant something.

If Donald had, he might not even have bothered with the high jump, and this little man would have been world champion instead:

stefan holm no 10 000 hour man

Stefan Holm next to Patrik Sjöberg

Stefan Holm (181cm, 5″11  1/4) trained more and better than any other high jumper in the noughties and jumped 2.30m or more 119 times, but, e.g., never 2.42m like Patrik Sjöberg in the middle of the photo above did.

Sure, you’ll get better, the more you practice, but there is nothing guaranteeing becoming a master, no matter how much you practice. And, if lucky, you could get there much faster.

There is no 10 000 hour rule

 

The opposite of spending your life on just one endeavour

-I’m a trysexual, I’ll try anything once

The singularity is near

The singularity is near

Okay, I wouldn’t go that far, not in horizontal hip-hop, and not as a general rule either.

However, there is a 20-hour ‘rule’ that is immensely more useful than both the 1-hour and the 10 000-hour dogmas:

If you focus and practice intelligently for 20 hours on learning a new skill, you will become “quite proficient”

In 20 hours you can become good enough to enjoy your new skill, good enough to keep learning more on your own and good enough to know if it’s something you have a talent for and would enjoy developing even more.

If you’re interested in how to acquire a new skill in 20 hours, check out Josh Kaufman’s TED talk from March 2013. 

 

Studio 50:1

 

1 50 efficiency principle Sprezzaturian retarded hedge fund manager 2

1% effort for 50% of the outcome

 

110%

Sport jocks sometimes claim to “give it 110%”. Now that’s just retarded.

And it’s not due to a lack of education. They typically got the expression from their (gym) teachers. Anyway, never aim for 110%. You will be disappointed if you do.

 

20%

Google famously (used to) let it’s employees spend one day a week on any project they like. That’s 20% goofing around to let creativity flow, and maybe come up with significant improvements and business ideas.

I think Google has restricted the extent of its experimentation hours lately. They are still hanging on to the principle though. And so should you. Just because you’re grown up, doesn’t mean you have nothing more to learn. Actually, it’s quite the opposite. The older you get, the more you need to make a deliberate effort, to keep novelty and personal growth in your life.

 

1% effort for 50% of the outcome

Whereas 1 hour probably is more than enough for most of broadening your bedside horizons, and 20 hours is good for trying out what skills match up with your preferences and talent… I’d say, if you put in 100 hours (just 1% of the infamous 10 000 hours) you will leave most of mankind behind in that area, often achieving about half the level of a professional.

Call it the 1% effort system. People will keep referring to Gladwell’s 10khr, and so can you. But rather than go for the full Monty, aim for just 1% of the 10k, i.e. 100 hours of focused and deliberate effort to kind of “master” a new discipline.

You won’t win any championships but you’ll become pretty good at most things you try; typically much, much better than any beginner. Languages, sports, programming, design, sales, psychology, you name it. 

Since you have a lot of 100 hour chunks at your disposal, you can become an instant expert in hundreds of useful or entertaining skills. If nothing else, you can find out where your talents are and what satisfies you the most, rather than arbitrarily choosing chess, golf or tennis and end up wasting 10 000 hours on something you don’t really enjoy and won’t win at anyway.

In 100 hours you’ll acquire most useful skills regarding long term value investing, but you’ll still not be done by 10 000 hours

A sell-side analyst spends 10 000 hours per large cap company he covers during the course of his career. You could catch up on the essentials in just 5, and become somewhat of an expert in 20, not to mention a 100

Even more importantly, trying new things, practicing them wholeheartedly will increase your brain plasticity; hence future learning of other skills will be easier.

It’s fun too. Being a beginner is fun. There are no expectations, no anxiety, just a steep learning curve and a lot of hilarious failed attempts.

Commit and quit. Give it your all (yes, 100%, or close to it, but not for long, not for 100% of your life). Focus! Be serious. Give it one hour, just one hour. Then one more, just one more.

If you’re not completely hooked after 20 hours, try something else. The brilliant thing with the 20-hour system is that you can try so many things before deciding what should stick. If it’s useful and enjoyable enough, keep going until you get to a 100 hours.


The 1:50 rule in practice

Last summer I read the unabridged 2400 page book The Count of Monte-Cristo in French to improve my French.

I spent about 100 hours on learning the basics of Portuguese on DuoLingo last spring.

For no other reason than exercising my brain.

However, if you want it to really stick, it’s advisable to have a specific use for any skill you set out learning.

Commit and quit. Restart.

Fair disclosure: I quit both this year’s handstanding and side split efforts after just a few hours, due to lack of interest and slight injuries. Perhaps next year. 

I spent somewhere between 20 and 100 hours on Khan Academy’s math section, but now I’m taking a pause. I’m not sure how much time I put into Python and Javascript on Codecademy and Khan but probably around 25.

What I really should focus my next 20-100 hours on is online marketing skills, such as web design, SEO and writing copy. There are always new things to learn, new skills to attempt.

 

Working out, the 1% turned into 2%

I’ve tried several martial arts, tennis, volley ball, football etc. Martial arts is the only thing that managed to keep me interested long term, but my work schedule forced me to quit.

I took up weight lifting (again) in 1996 to keep in shape “until I could get back to martial arts” but I never did, and now I’m hooked by the iron instead.

I’ve typically always spent 1-2% of my time working out (more before I turned 22), and since I retired I’ve stabilized at around 2%.

I work out 4 hours a week, in practice 2% of the available time, doing mostly heavy compound exercises with free weights. In fact, most of that time is resting between sets, which I spend reading and writing.

I don’t do any specific cardio, except for a quick warm-up on the tread mill before working out.

I’m by no means a bodybuilder as such, but I am quite fit, despite sitting at an office desk for 20 years and eating whatever I like, including a lot of french fries, ice cream and drinking my fair share or more of alcohol.


Cooling down after a sauna:

post sauna cooling down

The picture above is the result of a 1% effort that got me hooked and expanded to 2%. By focusing on the most effective exercises, I look and feel athletic at 43, despite only going to the gym for about 90 minutes every second day (including 5-10 minutes of mobility exercises every fourth day).

There are no 110%, 100% or such efforts in my diet either. I fast (16:8) and I drink fish oil. That’s it. I still bench 300+ lbs, I haven’t had a cold in 9 years and my Omega 6:3 balance is exceptionally low at 2.0. 

 

Summary – Hard made easy:

  • Forget about the 10 000 hour myth. There is no spoon.
  • Try just one more skill, then one more, for a limited amount of time
  • Commit and quit. Don’t get stuck, don’t force feed yourself skills you don’t like or need
  • Give it 1% and enjoy half of the master level – the Sprezzaturian way
  • Even if you don’t use the skill per se, your learning ability is improved or maintained

 

Did you like the article? Share it with a friend or your social network. Tweet about it. And if you haven’t signed up for my newsletter and eBook, please do. There is a new eBook in the works – with hundreds of tips and tricks like the “1:50” and “Just one more” rules.

Amazon redux – this time twice as expensive

Warning, this is a long hard-core finance article. It’s mostly about the valuation of Amazon. The stock is so expensive, I can’t even… My blue sky scenario is -90%.


 

March 2000 was a good year for drunks…

amazon meme

I’ll show with a few simple assumptions and calculations why I think Amazon’s shares are 10-20 times as expensive as I would find attractive.

I’m not advocating going short the stock though. You have to realize when you don’t “get it”. At this point I’m not quite sure what would change my mind about this. It’s just so far off from what I consider reasonable that the situation simply is out of control. Hence, better not risk any money.

All I really do in this article is extrapolate growth and margin trends, and then state what kind of return I demand from an investment to consider it worthwhile.

You are free to have different preferences or assume others (i.e. the market) have.

Read on if you are interested in a step by step pedagogical approach to back of the envelope investing

Beer or IT stocks?

beer darth vader

At the height of the stock market bubble in March 2000, you would have been as well off financially if you bought beer and recycled the cans (in certain states), than if you “invested” the money in many IT shares.

As it were, the entire Nasdaq index (not only tech stocks) declined by 80 percent, and many stocks declined by much more. Just cash would of course have been so much better than beer, not to mention bonds or gold.

The difference between an 80% drop and a a 90% drop is an additional fall by 50% in value.

And yet another 50% loss takes the total loss to 95%. A third sequential 50% loss, after the initial hypothetical 80% plunge, renders a total loss of 97.5%, which aptly describes the trajectory of many IT and new media stocks during the years 2000-2003.

 

Stars do fall; Nasdaq composite index 2002-2015

nasdaq 25 sept 2015

I should know, since I was chiefly (ir)responsible for buying shares in an internet consultancy called March 1st (named after its starting date March 1, 2000, at the very peak of the bubble). Luckily, we made back the initial losses on that position (and sold it before the bankruptcy in early 2001). We then went on to earn so much more shorting similar stocks in Europe, using the US stock market as a template.

Make informed investments, with whatever you have left after Mr Market taught you a lesson – always be investing

The IT crash was no surprise

To many thoughtful and experienced investors the crash of 2000-2003 didn’t come as a surprise. I have a list of 50 prominent investors and other pundits, that intelligently and timely forecast an epic bursting of the insane IT bubble. Many of those went on to correctly predict a housing crash and a financial crisis after 2006.

Neither of the last two crashes came as a surprise to anybody with the slightest knowledge of the art of valuation and the history of markets and bubbles. The timing, however, was often off by a year or two – or more. 

Crash number 3 is in the cards

I think it’s about time again for a correction of frothy share prices. And by correction I mean on the order of -50%.

There are dozens, if not hundreds, of fingers pointing to that conclusion, but this is one of my favorites:

Dr John P Hussman’s chart over “Price/GDP” vs. stock market returns

Observe, e.g, where the blue line bottomed in 2000, correctly forecasting ten years of negative annual returns 2000-2010. Or peaked in 2009, forecasting 12% annual returns 2009-2019 (with the market so far well on its way to fulfill that prophecy).

hussman 14 sept 2015

Chart from here at hussmanfunds.com

  1. Notice the tight correlation
  2. Notice that when correlation falters for a while, it comes back with a vengeance. Actually this “error” in itself makes a better job predicting market returns than the revered “Fed model”
  3. Right now, market valuation points to negative annual total returns, including dividends, over the coming 10 years
  4. Usually the market corrects to levels where you can look forward to 10-20% annual returns over the coming 10 years. To get to that point the market needs to fall by 50-75% or stay level for 10-15 years. Which do you think is more likely?
  5. A vertical move upward by the blue line is tantamount to a stock market crash, thus changing the valuation from promising, e.g., 0% return to promising 10% annual returns the following decade.   

 

Amazon – buy the merchandise not the shares

I  have bought 2 Kindles from Amazon and hundreds of books. It’s a great company – for its clients.

However, let’s take a closer look at Amazon’s shares as opposed to their services. A quick visit to Market Watch tells you the stock price is 528 USD/share, with a total market cap of 251 bn USD.

There is no useful information on valuation, though, (since Amazon operates at a loss and doesn’t distribute dividends).

So, what do you do? Ask your friendly neighborhood hedgehog?

-No, you do the math yourself. If you consider yourself a real investor, that is. But first, let’s find out if you’re cut out for this. What kind of money person are you?

 

Amazon’s share price 2002-2015

Amazon 2002-2015

N.B. Amazon’s stock price has already fallen by >50% twice, and by >30% several times

 

Astute Investor or Ignorant Speculator

  1. Active or Passive. A passive investor buys and holds single stocks or index instruments -and never sells. An active investor buys and sells at various intervals, depending on a multitude of factors (we’ll get to that later)
  2. Single stocks or index investing. If you chose index-only investing, forget about Amazon (duh!)
  3. Fundamental or Technical. Are you willing to make an effort to understand what you invest in, do the math so to speak, or are you more inclined to speculate on tips, momentum, stock charts etc?
  4. Hope or Safety. Will you trade on hype and hope, on blue sky scenarios, or do you have the discipline and patience to wait for opportunities that offer a margin of safety

If you are an active investor and single stocks focused you can proceed. If you are passive, just buy the stock or an index already and go back to sleep.

 

See. Pretty picture

If you just can’t be bothered with math, spread sheets, forecasts and economics, do what so many others do: draw pretty pictures in stock charts and invest according to the patterns you think you can discern.

Or just follow whatever momentum or trend you want to see or you are told (tipped) about by a “friend” or broker. Just don’t blame me when you go broke.

technical

lines in a chart are not real

 

Your broker is your adversary

Stock brokers don’t want you to make good investments. They don’t want to be your friend.

They want you to pay a commission.

When you buy, somebody else sells. One of you is often making a mistake. And the broker couldn’t care less.

Charlatans (stock brokers and company representatives) use extremely simple and misleading measures of valuation such as some future year’s Price/Earnings ratio (given made-up profit margins), perhaps complementing it with an arbitrary, historical growth number.

“Amazon has increased its number of employees by 38 per cent in the last 4 quarters and at ‘normalized’ operating margins of 10% it’s trading at an EV/EBIT ratio of just 21.5 x (12 months forward op. earnings), i.e., only half its (employee) Growth rate! PEG=0.57 which is below 1, hence BUY!”

Assumptions: TTM sales of 95.8bn in June 2015 will grow at the same 17% rate the coming four quarters to 112.1bn. The operating profit at a 10% margin will be 11.2bn. The current EV is 251bn-10bn cash pile=241bn. The EV/EBIT thus comes to 241/11.2=21.5. The growth rate used in the PEG calculation is the last known employee growth rate.

 

Stock pitch break down

The above may sound convincing. But if you look more closely you’ll see the cracks in the facade:

  • Okay, so the number of employees grew by 38%. Even if it could be representative of future growth in some cases, it’s also a cost now. Sales, however, only grew by 17% the last four quarters (despite a 36% growth inemployees in the preceding period), and slowing. Thus, a better forecast of sales growth going forward would be 15%, given current trends.
  • In addition, the relevant growth rate, for applying a valuation multiple, is the growth rate going forward after the year of the multiple (which probably is even less, given the deceleration the last few years). Actually, unless profitability accelerates soon, Amazon needs to taper its hiring pace, which should hurt sales growth even more. Nevertheless, let’s give them the benefit of the doubt for now and assume 15% sales growth. We can refine the model later.
  • “Normalized” profit margins at 10%? Whats “normal” with 10%, when actual margins have been between 0-1%? Are there any plausible reasons to forecast higher margins than what Amazon has produced the last 5 years?
  • Actually, there might be. If Amazon reaches ‘scale’, when growth diminishes, margins could increase. This is the trickiest forecast of them all, since Amazon hasn’t reached “steady state” with sustainable growth and margins, so what to do?
  • Look to similar companies for guidance on potential margins. Also make a sanity check on what ROE those margins imply for Amazon (Return On Equity). Few companies stray outside 5-20% ROE for long. A higher ROE draws in competitors, and a lower ROE is a waste of capital. Assuming Amazon can increase its net margin to 1.5% (operating mgn approx 2%), Amazon will make a decent 14% ROE (1.5%*112bn/11.768=14.3%). Hoping for more is just that; hoping and believing the hype.
  • EV/EBIT-ratio of 21.5. Why is that supposed to be cheap in an absolute way? How can you tell? To start with it should be compared to profit or cash flow growth, which (at steady margins) can be approximated by sales growth – in our example at most 15% (probably less after 2016). Suddenly the PEG is 21.5/15=>1.43 instead of 0.56. That still doesn’t say anything about whether it’s a good buy or not, even if it can be compared to other listed companies’ PEG ratios. Anyhow, it’s apparently a lot more expensive than what the broker first said.
  • And, I almost forgot, that was based on a 10% op. profit margin. Assuming 1.5% instead, renders an EV/EBIT of 143 and a PEG of 10. That is 19x expensive-er than the broker was saying.
    • In addition, whatever happens in 2016 is less worth than if it were today, so profits should be discounted by your required rate of return. An EV/EBIT of 143 a year from now is some 5-10% more expensive than the same multiple today, or >150. That however still doesn’t answer the question whether Amazon’s stock is expensive. Do, however, compare the 150x on trailing EBIT to the more typical 10-20x multiple seen in the S&P 500 index. Enticed?
  • Continuing to use the extreme simplifications above, you can calculate an earnings yield to see what your actual return would be in a single year. If you dare extrapolate that year indefinitely, you can even rely on it as the stock yield. In Amazon’s case, given 1.5% operating profit margin and a 30% tax rate the net profit is 112*0.015*0.7=1.18 bn and its earnings yield is (profit/market cap) 1.18/251 = 0.47%.
  • If you are lucky all this profit generation is converted to cash and distributed to you in some way. Also, if you are lucky, the coming four quarters are representative of the coming eternity for Amazon’s business (in practice only about 50 years count).

There you have it. Given a set of simplifications, you can expect around 0.5% yield on an investment in Amazon. It doesn’t really say anything about what price you’ll be able to sell the stock for in the future, but if you just hold on to it forever, you’ll get an 0.5% annual return on your investment, unless Amazon’s business changes radically.

 

The quick and the dirty

Happy? I’m not. And that’s not because of the low return, or that the stock might (should) fall dramatically in the meantime (to a price where you could expect at least a 7% annual return). It’s because of all the simplifications.

Just because you put a lot of numbers down on paper doesn’t mean they are correct or you are any wiser

 

Also note that, if in the future, when you want or need to sell the stock to get your capital back, another valuation paradigm dominates, perhaps demanding the historical 6% or 10%, 15% or even 20% return on equity investments, the Amazon stock price will be proportionally lower.

At a 9% required return, Amazon’s stock price would be just a twentieth (27.50 USD/share) of what it is at 0.45% required return.

That was the quick and dirty way of analyzing and valuing single stocks. You should at least do as much for any stock you contemplate buying.

  1. Estimate (extrapolate) sales growth and margin trajectory in an informed manner
  2. Calculate future profits and cash flow that take into account total available market, innovation and competition
  3. What yield in relation to the company’s market cap does that cash flow produce?
    1. If you’re happy with that yield and don’t care if the stock falls in price, you’re good to go
    2. If the yield is below your required return (9% for example) or the historical market return (7%) and you do care about price fluctuations, tread carefully. 
  4. Is that enough? Are there better alternatives? Is it enough for others (i.e., the market)?

 

Get out of here!

If you felt that was already too much, you are not an active or fundamental investor. A sell side analyst does a lot more. It’s not necessarily better or more effective but it’s impressive work.

 

The long winding road of doing sell side level research and stock analysis

Make company forecasts like a ‘pro’

  • Make reasonably detailed Profit & Loss, Balance Sheet and Cash Flow forecasts. These are hundreds or thousands of Excel rows long, several hundred columns wide and dozens of sheets thick 
  • To do that you need to forecast sales, costs, wages, investments, loans, interests, taxes, dividends, buybacks etc
    • Any one of those components can be forecast using a dozen other inputs
  • To do that you need a view on demand, competition, currency (FX) trends/fluctuations, technological development etc.
  • You also need the company’s history to have an inkling of how its products have been received by the market and how management has been able to juggle all variables historically.
 
In addition to this fundamental single stock valuation, you should add a handful of supportive layers:
 
  • Total market valuation (if the stock market in general is “cheap” you stand a better chance the entire market will rise and help your shares appreciate. The latter, however, only really matters to a hedge fund and not for a long only index fund)
  • Momentum in the stock or the market (positive market trends can lift all boats)
  • Risk tolerance, i.e., your willingness to gamble (and willingness to lose)

Stock prices move in cycles. Sometimes a certain industry or company is in vogue and sometimes it’s not. You can try to speculate blindly with this momentum or you can choose to invest whenever the price (valuation) is below a certain maximum threshold and sell when it is too high for a comfortable plausible return. Dare to make your own judgement of value and buy when others don’t.

It’s better to look the fool before, than after an event

 

Analysts make meteorologists look good

There is no secret to forecasting. No one can do it anyway and stock market pundits and economist are among the worst forecasters of all.

I think my complete immersion in finance for a quarter century is why I have always marveled at the accuracy of weather forecasting (no irony, I am amazed of what they can do).

The following can serve as a rough guide to informed forecasting of financial data. But remember that your forecasts don’t become the truth just because you put them down on paper.

Collecting historical data

  • Get at least five to ten years of history for a simple set of parameters for the P&L: sales, cost of goods, cost of personnel, cost of loans, taxes
  • Make a rudimentary balance sheet: real Long-Term assets, goodwill and intangibles, Short-Term assets, cash,  net working capital, equity
  • Cash flows: operating profit after tax, investments, changes in Net Working Capital
  • Double check for funnies: too low wages vs history or vs. competitors, high personnel option compensation, share count development; profit, cash flow and equity not adding up over the years etc. Make charts of every series and subseries you can think of an look for kinks, trends, holes, bumps and so on. Then investigate those by reading old Q-reports, ex ante guidance commentary and ex post explanations.
  • Check the latest quarterly trends more carefully: DSOs, e.g., (Days Sales Outstanding=accounts receivable/sales) = how easy is it to get paid, is the company overselling or even sending unsolicited invoices?
 
Making forecasts like a baws
 
  • Find leading data series in daily, weekly, monthly or quarterly data: from competitors’ sales, costs etc, weather data, monthly national data, PMI surveys, national industrial output statistics, retail sales, FX, etc
  • Start forecasting: Basically extrapolate trends in historical company numbers and leading data series. Allow for cyclicalities and reversions to the mean. E.g., profit margins and Return On Capital Employed numbers tend to gravitate to a mean for the industry or the economy. Do not expect super profitability or super growth for eternity. Check how long the very best companies of all time sustained their growth, margins or returns. Check what the average company did, including those that failed and are no longer here. Easiest is to check nation wide numbers for margin and growth trends.
  • Analyze really long cycles (over several decades or longer) and trends to make sure you don’t get myopic, narrow sighted, seeing only one half of a cycle and thinking that is a long term trend to be extrapolated without risk
 

Knowing what you don’t know

All of this is particularly difficult for new companies and even more difficult if they operate in new industries. There is no history, no precedent. That doesn’t mean you get off more easily. Quite the opposite. The risk is higher and your work is harder.

Sell side analysts take advantage of the lack of data, and of the general optimism, to forecast blue sky scenarios, luring in buyers. Rising share prices then act as (false) evidence the forecasts are correct.

Typically, new companies are valued using new (i.e. unproven) key indicators; like clicks or eye balls or users, no matter if the latter are paying customers or not. Some even use costs as a key indicator, when there are no sales. The more costs, the more losses, the higher the value… Biotech analysts have been trail blazers within ‘cost valuation’. The more biotechs spend and lose, the more they’re worth -until they’re not.
 
 
Let’s not forget about the smoke and mirrors of three-letter abbreviations.
 
There are only so many three-letter combos to go around. Consequently the same three letter combos mean diferent things in different industries and at different times.
 
That’s not a flaw, it’s by construction. It’s supposed to create confusion and make the client or outsiders feel inferior, afraid to look stupid. The companies first make some analysts feel stupid who then turn around and fool their clients. Oh, it’s a WAP company! Buy. They have a BTC mechanism and make a ton on OEM…
 
Don’t fall for the simple three letter abbreviation trick
 
Ask and ask again until everything’s clear. Then make reasonable forecasts not based on 100% market share forever, constantly rising margins, and world domination of this industry and ten more nearby.
 
Take a minute to remember all those formerly glorious companies that perished and disappeared in the 2001-2003 downturn, despite all the thre-letter combos in the world in their Power Point presentations.
 

Don’t forget geographical trends, product trends… to see if, e.g., the first markets, the home markets are losing steam, or perhaps if new markets are small but growing quickly – which might not be visible in overall numbers otherwise. Slice and dice numbers in all directions and look for S-curves, tapering, bumps and exceptions.

Typically it takes at least a few years to get reasonably good at doing fundamental research, and at least a week to build a basic valuation model for a single company. It’s hard work and it’s complicated but it’s worth it if you have a nest egg worth a handful of years’ income to invest.

Professional analysts have spent years on their models, but that’s going overboard in my opinion and only meant to impress clients.
 
Equity research is at its foundation very simple; don’t let anybody tell you it’s best left to professionals. Just make sure you know what you know, and be honest to yourself about what you don’t know and what risk that entails
 
 
Less is often more
 
Most important of all, don’t make your model larger than what you’ll actually keep updated.
 
equity research
 
Don’t fill it with more data than you’ll actually use.
 
Erase whatever is unnecessary. Ask yourself, does this particular data series affect the final valuation in any way. If not, get rid of it.
 
And, again, it’s not true just because you wrote it down, or based it on an extrapolation of series of numbers. The future is inherently unknowable. It can’t be foretold. Less things happen than could have happened and we never know fully beforehand which one’s it’ll be. We don’t even know ex post what caused a certain future to come into being.
 
Don’t supersize that model, please
 
 
 
Stopped clock markets – or analysts

Stock prices and stock markets very seldom reflect the true long term value. Just as a stopped clock shows the right time twice a day (in Europe, actually only once), the stock market is valued more or less correctly about every six years or so.

That’s a good thing. It’s something you can profit from; if you have the guts to take a contrarian view when everybody else is screaming sell or buy. Or the guts to run with the lemmings for a while longer, even after the fat lady has finished her aria.

Markets are not weighing machines, they are beauty contests (in the short to medium run). They don’t find the correct value of a stock and stay there. On the contrary, markets forces of fear and greed create trends where the (perceived) prettiest stock is bought and the ugliest sold, until something, anything, changes and the trend reverses.

 
This makes stock prices and markets oscillate (in cycles of decades) around the true value. In the short term prices oscillate around some perceived popularity value.
 
The long term cyclicality creates twin opportunities for you as an investor: 1) follow the momentum, and 2) buy low, sell high. I think you should try to do it all:
 
  • Buy whenever a stock or an index is reasonably valued, or cheap, even if the trend is negative. Keep buying small increments.
  • Ride the momentum until it seems to stop (market dispersion crosses a threshold) or valuations venture too far out in the 5% tails
  • Sell if it is extremely expensive, no matter the trend, but don’t go short until market dispersion tells you risk aversion is high enough.
A precise depiction of professional investors in action
 
 
 

Hype and Hope is not a strategy
 
 

Don’t rely on blue sky scenarios. Very few companies hit it big. Why would yours? Perhaps just because you are looking at it (quantum mechanical interpretation).

 
Inoculate yourself against rosy forecasts by checking old stock market tables and company histories. Where just a handful succeeded, hundreds fell into oblivion or exhibited mediocre numbers.
 
Remember that you are only looking at the winners when looking at the current stock market
 
In fact, even the very best, the hundred top cash flow growers f all time, the Warren Buffets of listed companies, didn’t grow faster than 20% per annum for more than 20 years. OK, that fact needs to be checked, and many do manage to grow 100%+ per year for a few years, making compound numbers very impressive.
 
However, once growth falls to 20-40% per year there are rarely many years of >20% growth left. But, don’t take my word for it, look for yourself in the industry your current pet stock is operating in.
 
 
Status: It’s complicated
 
In the end it all is unbelievably complicated, despite there being just two possibilities at any given time: Up or Down?
 
There are thousands of professional investors, if not millions, trying to make money on the market, using different strategies. There are scores of companies competing for the same client wallet share. Remember that company management often get their forecasts completely wrong at turning points, so how could you beat them at their own game?
 
Don’t just flip a coin and hope for the best. Do the only thing very few investors do.
 
Pay attention to long term fundamentals, be patient and only buy when you have a decent safety margin, in terms of returns and think you can hold on forever and be pleased with that.
 
Don’t run with the crowd, unless you know what you are doing.
 
  • Don’t hope to sell the stock to a bigger fool
  • Don’t hope for efficient markets having priced all shares correctly so you can just wander in and buy blindly
  • Don’t hope that just any old stock will work as a hedge against inflation and money printing.
 
 
Equity research, explicit summary
 
  • Equity research is really easy and impossibly complicated at the same time. Just as life in general. Decide what type of effort you are willing to put in and what level of risk you accept. Just be explicit about it
  • Decide what kind of an investor you are. Active? Fundamental? Single stocks or index? Technical overlay? Gambler? Act accordingly
  • Do the math properly if you are going to do it at all. There is no big secret to forecasting; just do it, and be clear about your premises at all times. Make plausible and reasonable forecasts that are internally consistent. Double check your variables repeatedly. Believe the hype if you want; make a leap of faith in a product if you want, but make sure you understand that is what you are doing. Be explicit in your extreme assumptions.
  • Cheap or not? Compared to what? To your required return? To your marginal borrowing costs (your most expensive loan if you have any), to what you think the market’s marginal required return is or will be in the future? Compared to other stocks? Here is an overview, a check list, for doing equity research.
  • Decide on timing: It may be cheap, but markets are trending sharply downward. Then don’t buy until things calm down, or be prepared to ride a long downturn. Pace your purchases, buy a tenth at a time unless you have a specific game plan.
  • Wait. Be patient. Don’t expect good opportunities just because you are looking right now. It may take years for real opportunities to arise, whether it is about stocks, finding a life partner or a dream job. It can take 20 years for fundamentals to manifest themselves (though 8 years usually is enough). If you bought on the right side of cheap, time will work for you. In the meanwhile you accumulate dividends and perhaps buy more shares.
 
 
Addendum: The blue sky scenario is Amazon trading down by 90%

My best guess is that Amazon’s sales growth will fall slightly each year from 17% to 15%, from 15% to 10%, and sooner or later from 10% to 8 to 5% (assuming around 5% nominal growth rate for the economy in general).

Just spending a few hours with Amazon’s numbers, I think it is 10-20x as expensive as it should be. The current growth rate is only 17% per year, despite expanding its staff by 38%, and the company is hardly making any profits.

A year ago, when I last looked, sales growth was 20% and employee growth 36%. Fundamentals are not getting any better.

Assuming a decent 15% ROE in the future implies 1.5-2% operating margins and not even a 0.5% earnings yield (net profit/market value).

I would require at least 10-20x that return, i.e. 5-10% annual return on my investment, to bet on Amazon succeeding in its endeavor to sell everything to everybody. Consequently, the stock price needs to fall by 90-95% to satisfy my return requirements.

In addition, I can’t see any reason to assume growth or margins expand meaningfully in the future. Rather, I am worried growth will taper faster than most expect and that margins might fall to zero or below. I know the market believes and assumes Amazon can raise its margins to 5-10% as soon as it wants to, as soon as it concludes its hypergrowth phase (17%, remember?). It’s just that you seldom see those margins in retail. Ask Wal-mart.

In my opinion the blue sky scenario is Amazon trading down by 90%. The base-line and worst case scenarios are that Amazon falls even more and becomes completely irrelevant and taken off the market.

So, what should you do? Well, not buy Amazon, that’s for sure.

There are tens of thousands of other listed companies worldwide, many of which look more interesting than Amazon.
 
And if they are all too expensive, just wait. I’m sure you will get a good opportunity within the coming ten years, and in my opinion, most likely within two.
If that seems too long to you, you just aren’t fundamental enough. Go play with the chartists instead.
 
 
Final words; do this
 
1. Make the simplest possible models for your current investments. Spend about an hour (or less) on each company to begin with. What sales, margins, and valuations are required to make you happy? When? Is that plausible? If not, contemplate selling – not least given the extremely high general market valuation environment. But read my disclaimer first.
2. Sign up for my newsletter and free e-Book to stay up to date and learn more
3. Share this article with a friend that’s gone deep into story stocks
 
 

Think like a child, like a freak

The other day, I wrote about trying new non-intuitive habits and creating your own Retard’s Playbook or lifehacking manual.

Here I expand on a method to solve problems and find unexpected solutions, including just asking simple questions, being unbiased and taking the longer route from scratch, having fun and broadening your attention instead of focusing.

This article shouldn’t set you back more than five minutes.

 

Think Like A Child

I constantly try new methods to control my rescue dog while still being her friend and family.

The “problem” is that she wants to run up to other dogs. If she can’t do that immediately she barks (aggressively, although quiets down completely and wags her tail as soon as she is right next to the other dog). She is not the least aggressive or dangerous, but she can appear to be (she sounds and looks aggressive and is an 85 lbs German Shepherd-Doberman street breed).

think like a child aggressive german shepherd

“She’ll calm down if you just let her come close, I promise”

I’ve tried meatballs and sausages (throwing them on her, on the ground, shoving them up her face, in her mouth, just letting her sniff and lick the goodies and so on), I’ve tried verbal commands, physical cues (scratching, picking, gentle “fishing” with the leash), harsher pulling, wrestling her to the ground, turning her away, blocking her view, simply releasing her, sharp clapping sounds, click devices, running, slowing down, and so on. I keep trying whatever I come to think of.

My method with Ronja, as well as in other aspects of my life, resembles advice in a chapter of the book Think Like A Freak (a very serious competitor to my Retard’s Playbook) about thinking like a child.

Think like a child think-like-a-freak-book-cover-freakonomics-relationships

Much of what is said there is applicable to anything from dog socialization and gym training to financial investments (three of my main interests). The below childish advice is mainly ripped from the podcast Freakonomics last Thursday:

Have fun. It turns out Sinead’s doctor wasn’t the fool she thought.

An 8-year old can play complicated computer games for 8 hours, but could hardly handle a full time job at the supermarket. The key ingredient here is fun; if you actually like what you do you have an unfair advantage over people who just do their job.

I used to like researching stocks, understanding business models and not least develop models for their drivers, metrics and financials. That’s why I was good at my job as a sell-side analyst 1994-2000 and during my first 10 years as a portfolio manager. With time, it became more and more of just a job – a boring, meaningless and almost dishonest job, where fundamental long term research didn’t stand a chance against the machinations of evil and ignorant politicians.

Think broadly. Children have a much broader attention compared to the laser like focus of adults. Children therefore can reveal a magician’s methods and discover a fully visible person sitting in an unusual place in a mall that the adults never see.

As I’ve learned through earlier science podcasts, children are like the R&D department of a large company (sees everything at once, but focuses on nothing), whereas adults work with production and marketing. During my career, the ability to switch between micro and macro, between focus and a more holistic view turned out to be very valuable (first ranked analyst, as well as European Hedge Fund Of The Decade, remember?).

Later, when hiring new analysts, I let the applicants solve typical McKinsey-type problems that require the ability to jump back and forth between a bird’s eye perspective and the nitty gritty details of a problem. All the people we hired that way turned out to be very good at researching companies and their shares.

think like a child gordian knot

Ask simply. Children, newcomers and outsiders tend to ask “stupid” questions that sometimes resolve the Gordian knot at hand. Soon, however, adults feel too embarrassed to ask simple and direct questions, since they are supposed to already know the answer. This childlike behavior was particularly useful as an IT-analyst in the mid-90s, navigating new technology and 3-letter-abbreviations designed for misdirection. There was a time when all a company had to do was include the term WAP in a pressrelease to see its shares rise by 5-10% that day.

Start from scratch. A final suggestion for harnessing the power of children is to ignore heuristics. It is much more time consuming of course, but scientists and long-term investors (investment horizons of at least one cycle of 7-10 years) have everything to gain from ridding themselves of prejudice and bias. 

I’m sure all these traits are just as important in any creative profession, research or entrepreneurial endeavor as it was in the world of finance.

think like a child bach flute sonatas

Here is a tip on how to explore and expand part of your still childlike capacity for a broader attention span. Try to listen to the bass only in, e.g., Bach’s flute sonatas (like this one). When you do find the bass, the rest of the music manifests itself indirectly in your mind but much grander than before. But watch out, it’s very easy to get caught by the melodic flute again and lose the bass.

 

That mindfulness and unfocused focus Bach experiment reminds me of the 3D stereogramme pictures of the 1980s, like these two:

think like a child adult 3d stereogram

 

think like a child 3d sterogram

To see the 3D picture, gaze through the picture as if looking toward the horizon, or possibly the wall behind your screen. The picture in all its 3D glory appears after some 10 seconds.

 

Summary

  • Have fun
  • Ask “stupid” questions
  • Be unbiased
  • Lessen your focus and widen your attention
  • Try a simple mindfulness exercise like listening to the bass only in a piece of classical music

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