This is Part 3 of a series of posts that I’m writing to share my process for selecting and investing in growth stocks. The previous posts can be found here:
My third post in this series was going to be about the information that I retrieve and where I get it with respect to stock analysis. Instead, I decided to first focus on some thought processes relevant to investing. How an investor thinks strongly influences how thorough and good the analysis will be; this, in turn, will affect the investor’s returns. Investors will need to employ several different ways of thinking during the analysis. Several professions have inherent skills and/or prior training that are highly useful for stock analysis.
THE INVESTIGATIVE JOURNALIST
The investigative journalist seeks the truth, and she has skills and a way of thinking that help her arrive at the truth. What’s more impressive is that she can often uncover the facts when others don’t want them revealed. Thinking like an investigative journalist can help the investor uncover the truth.
Analyzing any company for possible investment begins with gathering information. The fidelity of this information underpins the quality of all further analysis.
The journalist has a knack for finding the best and most reliable sources of information. A primary source is the original material or information as opposed to a secondary source which describes or analyzes primary sources. When available, it is always best to use the primary source as it will be the most accurate and reliable. A secondary source contain mistakes or otherwise obscure the information. The most important information for analyzing stocks is the company’s financials. Secondary sources may reference revenue, profit, various growth rates, customers acquired, and other financials or key performance indicators (KPIs), but such secondary sources may not be reliable. For instance, when referencing earnings per share, a secondary source, such as YahooFinance!, may refer to GAAP EPS without specifying so. Or they may state that the company grew at 50% without indicating whether the growth was year-over-year for one quarter or for the entire year. If an investor inputs figures that are not right then the investor is prone to draw erroneous conclusions based on false premises. The only acceptable source of financials and KPIs is directly from the company via their financial statements (i.e. 10-Q, 10-K, company issued press release, or company investor presentation).
Investigative journalists are also great bullshit detectors. They pay close attention to verbal and non-verbal cues to assess a source’s truthfulness and tendency to exaggerate or excessively embellish. As investors, we should have a strong preference to invest in companies with managers we can trust. In fact, I won’t invest in a company if I don’t feel I can trust the CEO, CFO, or other senior executive. Listening to the quarterly earnings calls and other presentations and interviews provide a means to judge management’s ethics and integrity.
THE LAWYER
The lawyer has trained to become a master of logic. A good attorney not only has the ability to construct arguments to prove his case but also the skill to deconstruct his opponent’s argument to find and exploit weaknesses. Yes, a good lawyer can find a way to win even when faced with a terrible case while a bad attorney can manage to bungle a solid case. A key difference between a court case and an investment is that a court case relies only on the past (sometimes on the present in the courtroom during the case proceedings) but never the future; with an investment the past is an important guide to make probability judgments about the future. Nevertheless, the lawyer’s skill at using logic can be very useful when applied to stock analysis. I suppose you could say that constructing arguments to aid in analysis is necessary but not sufficient for achieving success in investing. However, while the lawyer must judge which facts are relevant to making and winning an argument and the case, the investor must judge which conditions are necessary for the company’s value to rise as a result of its success. A bad investment cannot be forced or made to be a good one by logic; therefore, an investor must be cautious not to force an argument as a lawyer might be inclined to do. An important aspect of the lawyer’s way of thinking, when applied to investing, is judging what is most relevant and what is irrelevant to the success of the business and the stock price appreciation.
THE SCIENTIST
Scientists utilize the powerful scientific method beginning with a problem or question and shepherding it through a process to produce an answer or a new theory. Below is a diagram illustrating the steps in the scientific method.
The methodical process used by the scientist to form a hypothesis and test it through experimentation, while not identical to the process that the investor uses to form a thesis and reassess it through seeking and gathering new information, uses a similar thought process and iterative reevaluation. The main difference is that the scientist plays an active role in designing and conducting the experiments, while the investor focuses on seeking and evaluating new information. But the way of thinking between the two is similar. To arrive at buy/sell/hold as well as position weighting decisions, the investor must continuously seek and assess new information. A flexible mind is needed to be able to replace previously held assumptions and conclusions when the results refute them. Getting too locked in to one’s ideas, assessments, and conclusions can be very detrimental to investment returns!
THE INVESTOR’S MIND
Utilizing all the important skills of the investigative journalist, the lawyer, and the scientist should provide the investor with an edge in his analysis and assessment of a stock. However, the ways of thinking discussed above are not complete and comprehensive for investing; evaluating companies requires additional skills and thinking. Perhaps that’s why AIs can’t yet beat the best investors. Later in this series of posts, I will discuss some additional skills that are valuable for stock analysis. One example is the ability to simultaneously see the details and the big picture.
The next post in this series will focus on gathering the information to begin the analysis.
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.