I’d like to thank my friend Clara for her right-brainer inputs. It did help a lot. If you’re a Portuguese speaker, I highly recommend her write-up for a different perspective.
“Even the most analytical thinkers are predictably irrational; the really smart ones acknowledge and address their irrationalities”.
Dan Ariely
Introduction
As we commented on Twitter on Saturday, we’re releasing a new post about Stone, its valuation process, and how each engine affects the overall picture.
So far, between updates, and deep dives, we have written twelve posts about the company, totaling over 180 pages in content.
Even though we’re proud of creating that amount of content in such a short time, we haven’t had such much about our thoughts on how to evaluate our writing.
Regardless of how careful we’re researching and reading someone else’s write-up, we might be charmed by a good storyteller, although we theoretically know how to shield our minds.
If you have been following us since our inception, you probably noticed that we are left-brainers (logical). More recently, we’ve been developing a new set of skills for storytelling.
For that, we see ourselves in the position of helping investors and equity research analysts to develop a set of soft skills when reading someone else’s writings.
We Are Irrational
We inevitably have to deal with various individuals who stir up trouble and make our lives difficult throughout our lives.
They can be aggressive or passive-aggressive, but they are generally masters at playing on our emotions. They often appear charming and refreshingly confident, brimming with ideas and enthusiasm.
Only when it’s too late, do we discover that their confidence is irrational and their ideas ill-conceived.
What inevitably happens in these situations is that we are caught off guard, not expecting such behavior. Often this type will hit us with elaborate cover stories to justify their actors or blame handy scapegoats.
We might protest or become confused and drawn into a drama they control. We might protest or become angry, but we feel somewhat helpless in the end — the damage is done.
We catch ourselves falling into self-destructive behavior patterns that we cannot seem to control in these situations.
If we really understood the roots of human behavior, it would be much harder for the more destructive types to continually get away with their actions. We would not be charmed and easily misled.
But why? What if we could see the source of our more troubling emotions and why they drive our behavior, often against our wishes?
Understanding that stranger within us would help us realize that it’s not a stranger at all but a very much a part of ourselves.
And with that awareness, we would be able to break the negative patterns in our lives, stop making excuses for ourselves, and gain better control of what we do and what happens to us.
Having a clear understanding of ourselves and others could change our lives. But first, we must clear up a common misconception: we believe ourselves as rational.
Look at greed, for instance. We usually identify a specific excuse or a group as the cause of this emotion. But if we were honest with ourselves, we would see that what triggers our greed has deeper roots.
We can discern the patterns if we look — when this or that happens, we get greedy. But at the moment, in getting greedy, we are not reflective or rational — we merely ride the emotion and take unnecessary risks.
Nevertheless, we like to imagine ourselves in control of the situation, planning the course of our investments as best as we can. But we are largely unaware of how emotions drive us.
They make us veer toward ideas that soothe our egos. It makes us look for evidence confirming what we already want to believe. On the other hand, rationality is the ability to counteract these emotional effects.
Rationality teaches us to think instead of reacting, to open our minds to what is really happening instead of our feelings.
Becoming a Storyteller
Research in psychology point to an undeniable fact. Human beings respond better to stories than to abstractions of numbers. So writing a blog has been helpful since we’re left-brainer (logical and analytic).
I don’t know for how long you have been following us, but our first posts focused on numbers and were tough to read. And it was hard for us to notice that.
For us, it’s so logical that numerical patterns are correlated, and anyone could simply connect the dots that I barely explained the narrative behind it.
However, after receiving the same questions, we realized that communication was improper, even though I had a table answering them in the post.
Humans have been using anecdotal evidence for thousands of years, and scientific arguments for only 100-150 years, so the way information is presented is more important than the information itself.
Of course, this is also true for businesses, where storytelling is much more effective at selling ideas than the number itself.
Building on the storytelling theme, a story told by someone who was part of it is viewed as much more credible than one told by someone from the outside – this is partially why we look for industry experts.
Unfortunately, creativity and numbers are mutually exclusive. Your pitch will succeed if you’re creative and your story is good, regardless of how creepy your financial figures may look.
For that, in a time of exuberance, when growth is the defining metric, differentiating a good and a lousy business becomes extraordinarily hard. So, we’ve been building our storytelling strategy differently. We use a backward approach for that.
Learnings From VCs
Have you ever wondered how great venture capitalists deploy their money into small businesses?
Now it’s very hard in the early, nascent, embryonic stages of a business to know if somebody will be an absolute genius or a total fraud.
Because the best storytellers are also the best con men. Unique narrative storytelling ability captures all of humanity's best and worst things.
It captures our aspiration, virtues, sense of status, desire, greed, and people that can tap into that, who understand people, I think are really influential with people, are almost always predictive of great success.
Somebody that is a great storyteller is perfect for a startup business because they can recruit really well. They tell a story where you meet with that person who is convinced to invest with him by the end of the meeting.
Every successful venture capital firm we’ve ever met always deploys the most sophisticated approach to cut the bull: “Sure, but tell me what sucks?” This is so powerful, yet most investors never ask this management.
If the management can figure out what sucks or how better the product could be, you’re probably dealing with a skilled con man.
Before writing it, we thought a lot, but venture capital is closest to a cheerleading business. The odds are so low that it is hard to believe in a different definition.
Promoting the future is betting against the status quo. If you’re old enough, remember politicians criticizing the Internet, calling it a scam, and saying regulators should put it down? That is more or less what you’re facing in a VC firm nowadays.
But we think that you have to anticipate what is everything that could possibly go wrong with this company so that you can help to put time and talent, and money to prevent those bad things from happening.
That is, in our opinion, the right approach for proper equity research. “Buy” recommendations run high as +80% among sell-side firms, even though most companies underperform the S&P 500 in the long term.
If you go over the reports, they’re usually pointing in the same direction, highlighting the same optionalities, and putting aside the risks.
Even though they may not be meaningful, investors should have access to them for weighing as they feel needed. That should not be revoked from them.
Critical Approach
As a newsletter firm, we are much happier occasionally saying stupid things. Our job is partly correct but partly to come up with bold ideas that nobody else would test or verify its eligibility.
The point of an independent blog is to create a place where you can make slightly silly calls and still be right about it.
If we create an atmosphere of roughness where readers will receive a square, non-provoking piece, there is no point in having an independent newsletter firm.
We have to have the confidence to say, “well, maybe management is not that stupid, and they’re working with a possibility of selling their firm.” Sometimes, this idea just kicks off, and we are right. We don’t know, though we’re willing to risk more than others researching a firm.
Our hunch is that nearly all things that you could define narrowly as equity research automatically, as an investor, there are two strategies you know. There’s the one-off game and the repeat game.
Any behavior which costs more upfront and only pays off over time, something which could be marketing expense for new customers, it could be a debt restructuring, replacing management, anything that costs now and only pays off in the long-term is a reliable signal of a business or an individual who’s playing the one-off game.
On the other hand, a company playing the repeat game will pay to care about its reputation and do well for its customers, which is usually a premium company, though you receive the prize immediately.
For us, you could define equity research as the costly signaling of faith in the company’s futurity.
The point is that once you understand satisficing, you realize that what we’re really trying to do when we make decisions is often it’s not to attain protection; it’s to avoid permanent impairment of capital.
We would argue that one of the reasons people pay a premium for stocks. In other words, they’re considering the expected utility and the variants.
If I buy Company A in the same industry, it might be $150 more to buy Apple than a peer that produces a similar product, but Apple has more reputational skin. They’ve got more to lose by selling bad products than company A.
So, Apple is playing the repeat game because they’ve been in the business for decades and invested a lot of money in advertising and new product development.
Sometimes, we don’t even want to know that Company A exists. Honestly, if you can spend an extra $150 and get Apple, it may not be the best on the street, but it’s less likely to be awful.
Our approach to investing and evaluating companies plays both games. Although we avoid those companies, we don’t mind investing in companies that will retrieve the value in the long term.
However, we go hard on numbers. We go over each footnote, talk to formers, and competitors, then list and evaluate risk. If the company thrives through our process, we may consider investing in it.
We internally argue that we’d rather lose money from failure to imagine failure than make stupid mistakes, such as expecting a miraculous operational turnover after a significant people turnover or vast financial losses.
From us, be worried if you don’t hear bad news and complaints about how stupid such capital allocation was. Our job is to bring provocative questions and bold statements.
As long as we can, we'll keep playing with odds and payoffs.
