I hate certainty.
I mean, I’m glad there are some immutable laws of physics and chemistry, but that’s about as far as I want to go.
I’m glad gravity is undeniable and consistent. I’m pretty pleased that hydrogen and oxygen combine in a two-to-one ratio to give us water.
But in other things? I’m allergic to the idea that we can be sure about anything.
First, though, let’s go back a few decades…
When I was in high school, I studied Commerce and Economics.
I can’t remember in which one of those I was introduced to the share market, but I can still vividly remember turning to somewhere near the middle of the newspaper to read through the share market tables.
ASX code, company name, market capitalisation, P/E, dividend yield, franking.
And when I say I remember it, I can still vividly recall the process of going line by line, trying to recognise company names, to find the cheap stocks (by P/E) and the ones paying the most in dividends.
Going a little further back, I can remember having a physical passbook (remember those?) at the State Building Society, and earning something like 6% or 7% interest on my (very meagre) savings.
In both cases, thanks to my teacher and parents, respectively (and, in all likelihood, an innate mental wiring for these things), I quickly understood and was in awe of the ability of being paid for doing nothing other than waiting.
When that interest just turned up in my account — $6 on top of the $100 I had saved — I was hooked.
“Six dollars!… for nothing!”
Dividends were the same. I’m pretty sure I had no idea how good franking was, at that point, but just the idea that you could make 3% or 5% from owning shares in a real business was mind-blowing.
Fast forward a few years, and I was nuts about investing.
Now these were the truly-ruly olden days, and the internet was in its infancy.
So I used to call up the Investor Relations department of ASX-listed companies, and ask for their last 5 annual reports.
I’d wait a week, and a fat envelope would arrive in the mail. Sometimes, the companies didn’t actually have any copies of their older reports, but most of the time I got what I was after.
I’d flick past the glossy pages, and go straight to the ‘cheap paper’ section, in which the financial reports were printed.
Balance Sheet. Profit & Loss.
I can’t remember learning about the Cash Flow Statement at university, and I can’t remember if it even existed when I started investing.
Yes, I did say it was the olden days!
There certainly was no Statement of Changes in Equity.
Still, it was enough.
I’d fire up my computer (it took a while) and open Microsoft Excel.
Then I’d meticulously type in all of the numbers from the P&L and Balance Sheet… for 5 years’ worth of statements…
I wish I could pretend I was cool, and that this was a boring, thankless task that I hated.
In truth, while I didn’t love having to type it all up, I knew it was the first step in unlocking the secrets of investing.
Because behind the data entry, I’d created a template that would turn the numbers into gold.
No, not literally.
But by making sure I put the numbers in the right cells, the spreadsheet would create all of the ratios and percentages I could want.
And by all, I mean all.
Gross profit. Net profit.
Sales and marketing as a percentage of sales.
Days sales outstanding.
Cash conversion ratio.
Quick ratio.
Interest cover.
Sales growth.
Profit growth.
And they’re just the ones I can quickly recall.
If I’m not mistaken, I had something like 40 different calculations, for each of 5 years (and the change in each, from year to year).
Seeing those numbers automatically calculate was (geekily) intoxicating. I had everything right at my fingertips.
I knew what was good and what was bad.
What showed things getting better. And worse.
The only problem was that I’d fallen into the same trap that plagues many a new investor — and some experienced ones — I knew “the price of everything, but the value of nothing”.
As Warren Buffett remarked, “If past history was all there was to the game, the richest people would be librarians.”
But I hadn’t yet learned that lesson. I had the numbers (and the ratios, multiples and growth rates!), and I knew the (inflexible) theory.
I knew which ratios were good and which were bad. Which multiples should be going up, and which should be coming down, if a business was any good.
I was, in short, an investing librarian-cum-theorist.
Which isn’t very useful.
In retreating to the certainty of black-and-white numbers and a suffocating number of calculations, I’d let myself believe I had all the answers.
Which I did… if the questions were all historical.
Unfortunately, in investing, they’re not.
Again: the price of everything, but the value of nothing.
See, it turns out that history isn’t very useful, for a couple of important reasons.
First, you can’t just extrapolate.
Kodak was a world-beater… until it died.
Woolworths Group Ltd (ASX: WOW) had world-beating margins… until they were shown to be unsustainable.
Newspapers had a lock on super-profitable classifieds ‘rivers of gold’… until the internet diverted them.
Second, calculating those numbers tells you exactly what everyone else already knows.
Sure, I had spreadsheets full of calculations for the most ‘important’ investing numbers, but so did anyone else who cared to do the same (let alone large fund managers and brokerage houses who had them well before I did!).
Woolies’ gross margins weren’t exactly secret.
It’s not like I was the only person who knew CSL Limited (ASX: CSL) was growing.
To be fair, people obviously still owned poor businesses — and avoiding them was an advantage that others seemed not to care about — but I wasn’t exactly uncovering nuggets of hidden value.
Third, I’d embraced some cast iron rules that, simply, weren’t very useful.
Instead of using them as indicators of superior value (or reasons to take points away from an investment thesis), I used them as hard-yes or hard-no decision criteria.
Management was selling? No way was I going to buy.
Inventory increasing? Trouble ahead.
Unprofitable? Way too risky.
By now, I hope the example is obvious: I was valuing absolutes over making informed judgements.
Socrates said the only true wisdom is in knowing you know nothing.
While I’m not one to get lost in fluffy philosophical thought, I’ve learned that there’s more truth in Socrates’ statement than many investors like to admit.
Discomforted by uncertainty, many investors try to find solid ground. But if (when) there isn’t any, they construct it in their minds.
They convince themselves that things are more certain than they truly are.
Perhaps they put total faith in a set of arbitrary rules.
Maybe they convince themselves that their favourite companies are stronger than they truly are.
Or they might create their own conception of a likely future, and come to believe that’s the only way things can play out.
Alternatively, buoyed by early success, they develop an unshakeable belief in their own ability.
And hey, maybe they’ve discovered El Dorado. Maybe they’re the next Nostradamus or Warren Buffett.
Maybe.
But if they’re not, such certainty is at best unhelpful and at worst can be disastrous.
As Mark Twain once said, “It’s not what you don’t know that kills you, it’s what you know for sure that ain’t true.”
I’m no Socrates. Or Buffett. Or Twain.
But their sentiments ring true.
The longer I invest (and the older I get), the more I realise I don’t know.
The more room I leave for doubt. And for error.
The more nuance I bring to my investing.
The more I realise that being wrong is part of the game.
And that the more certain I am, the more worried I should be — because nothing in life is certain.
I can’t claim credit for it — it’s long been a Motley Fool approach — but it’s also why we include a ‘Risks And When We’d Sell’ section in all of our recommendations: because something can always go wrong.
In my experience, it’s the approach that is most useful.
Humility beats arrogance, because you give yourself more room to change course, and you’ll likely learn something.
The more certain you are, the less likely you’ll leave room to seek out — or just hear — a disconfirming thesis.
You’ll know you’re right, long after your thesis has busted… or until bankruptcy, whatever comes first.
Instead, my approach is to utilise a group of ‘rules of thumb’, trying to tick as many boxes as possible, to put the odds in my favour.
I know I’ll be wrong, too.
That’s life. And that’s investing.
Success will likely come from being right more often than you’re wrong, and having your winners gain more, on average, than your losers cost you.
That’s not going to sell too many books. And it’s really going to annoy those who want certainty, and who will suspend disbelief (and reality) in order to get it.
I don’t listen to those who peddle certainty, or its close cousin, snarkiness.
Both suggest the peddler has an intellectual smugness that is both pretty distasteful as well as likely being unhelpful.
In investing, you either check your ego at the door, or it’ll cost you.
Fool on!
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Scott Phillips has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. The Motley Fool Australia owns shares of Woolworths Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.
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