Blind Stock Valuation as Deliberate Practice in Investing

With this post at GuruFocus, I am joining the blind valuation movement, hoping to help make it a more common form of deliberate practice for investors.

What Geoff Gannon started 1.5 years ago on his blog and what was last month written up at Distressed Debt Investing, is nothing more, nothing less than the teaching method used by the master himself – Ben Graham.

Ever since first reading Security Analysis, I have been thinking of making it a daily practice to do such blind valuations.  After struggling for some time to automate the process of obtaining historical data on random stocks in Excel, I gradually forgot about it.  But this time I intend to make it a habit before I become too busy or too lazy once again.

Looking at a company, or a pair of companies, without knowing its name and stock price is the only way to bypass some of the most persistent psychological biases investors, knowingly and unknowingly, succumb to.  And we are all very susceptible to

Psychological Biases

Generally, we loathe being proven wrong.  But we can believe we are right and disregard any information to the contrary, because the easiest person to deceive is one’s own self.  That’s the trickiest part about psychological biases – they are deeply rooted in the person we are usually least critical of.

Psychological biases are lurking in the shadows of our minds.  They can take many different shapes but the result is inevitably the same – a warped view of reality.

For example, juggling two conflicting pieces of information gives us headaches, which often leads to reconciling things in a way that eliminates the tension.  We accomplish this by reading information as it suits us and discounting conflicting information.  This is known as confirmation bias.  Shortly after investing in a company, you read that its flagship product is losing market share and may be obsolete in a year or two, but the company is also launching a new promising product.  Psychology says you are likely to gloss over the first part, focus on the second part, and conclude, Wow, what a great business.  I was totally right in buying.

Often we draw conclusions based on small, unrepresentative samples or, just as easy, using only the most recent information.  Or, some of us are overly conservative and fail to incorporate new information into their forecasts on a timely basis.  And to top it all off, no matter the outcome, a year later we would tend to remember that we were right.  Maybe our forecast was a bit off on this matter or that.  Maybe we missed the point completely.  Yet, the nature of our memory is to smooth these inconsistencies and keep our egos unharmed.

This is one good reason why so many investors write blogs, keep diaries, and intensely discuss their ideas with partners.  It is also why the best hedge fund managers, like Ray Dalio and Seth Klarman, have time and again emphasized the supreme importance of honest, open discussion that sets the ego aside and focuses on looking for the truth.

Good places to learn about psychological biases and behavioral finance are any of the books, papers, and presentations of Kahneman and Tversky, James Montier, and Dan Ariely.

Deliberate Practice

The concept of deliberate practice was first explored by Dr. K. Anders Ericsson (email me if you know his first name) of Florida State University in his paper The Role of Deliberate Practice in the Acquisition of Expert Performance (1991).  Dr. Ericsson is a renowned expert on expertise   One doesn’t get any more expert than that!  Chances are if you are seriously interested in investing, you have probably read about the concept that it takes roughly 10,000 hours of deliberate practice for one to acquire expert performance.  By studying the performance of professional violinists at the Berlin Music Academy Dr. Ericsson came to the following conclusion:

Most individuals who start as active professionals or as beginners in a domain change their behavior and increase their performance for a limited time until they reach an acceptable level. Beyond this point, however, further improvements appear to be unpredictable and the number of years of work and leisure experience in a domain is a poor predictor of attained performance (Ericsson & Lehmann, 1996). Hence, continued improvements (changes) in achievement are not automatic consequences of more experience and in those domains where performance consistently increases aspiring experts seek out particular kinds of experience, that is deliberate practice (Ericsson, Krampe & Tesch-Römer, 1993)–activities designed, typically by a teacher, for the sole purpose of effectively improving specific aspects of an individual’s performance. For example, the critical difference between expert musicians differing in the level of attained solo performance concerned the amounts of time they had spent in solitary practice during their music development, which totaled around 10,000 hours by age 20 for the best experts,  around 5,000 hours for the least accomplished expert musicians and only 2,000 hours for serious amateur pianists.  More generally, the accumulated amount of deliberate practice is closely related to the attained level of performance of many types of experts, such as musicians (Ericsson et al., 1993; Sloboda, et al., 1996), chessplayers (Charness, Krampe & Mayr, 1996) and athletes (Starkes et al., 1996).

This is from the revised excerpt from his paper.  It is important to notice that plain repetition won’t cut it even after 10,000 years.  That’s why it’s called deliberate practice, not just practiceRepetition is important only as long as it is directed at one’s weaknesses – learning from one’s mistakes.  Direction has to come from outside in the beginning, because the learner is not yet able to self-correct.  This is why great teachers are so important in our lives.  They are the ones that evaluate us critically, point out our mistakes to us and help us overcome them.  This cycle of improvement eventually leads to a higher state of learning where one can independently identify and analyze one’s own weaknesses.

Blind Stock Valuation as Deliberate Practice in Investing

Practicing valuation by valuing many, many different companies is great for beginner students of valuation.  This is when Buffett’s start with the A’s is most useful.  After having some basic understanding of accounting and the principles of value investing, the best one can do to improve one’s investment skills is go through the financials of loads of varied businesses.  You may prefer to start with the smaller A’s because generally the larger the company, the more obscurely legalese its disclosures are.  But in any case, you will be building your mental investment database.  Looking at groups of comparable companies is a great way to calibrate one’s general sense of the values and their drivers in an industry/group because people value things by comparison.  It is a simple and very intuitive approach to investing.  Geoff has a great article on peer comparisons as a means of valuation.

Taking the numbers out of context by removing the company’s name and price, takes your analysis one step further – away from your preconceptions about a company, industry, or time-frame.  Not that this information is not useful.  Sure it is.  But it is useful only later on.  At the start, it has too high a capacity to distort your objective judgment.  With name and price out of the picture, it is easier to be objective.

It is important to see this as one form of deliberate practice.  It is not an end in itself.  The numbers don’t necessarily tell the whole story.  Seeing beyond the numbers is a whole other level of understanding.  But that’s the essence of deliberate practice – varying your efforts according to your needs.

Don’t stop learning and challenging yourself.