{"id":59,"date":"2012-01-01T14:16:00","date_gmt":"2012-01-01T14:16:00","guid":{"rendered":"http:\/\/www.guythomas.org.uk\/blog\/?p=59"},"modified":"2022-06-03T13:44:36","modified_gmt":"2022-06-03T13:44:36","slug":"analytics-versus-heuristics","status":"publish","type":"post","link":"https:\/\/www.guythomas.org.uk\/blog\/analytics-versus-heuristics\/","title":{"rendered":"Analytics versus heuristics"},"content":{"rendered":"\n

One criticism of the investors in Free Capital<\/strong><\/em>  which I have heard from more than one expert reader goes something like this: \u201cThe interviewees say they are making investment decisions, but none ever actually works out what a company is worth.\u201d<\/em>  These readers then elaborate on the concept of intrinsic value<\/em> \u2013 the discounted future cashflows (DCF) of the company, as distinct from its book value, liquidation value or market value.  They suggest that \u201creal investors\u201d focus on this concept of intrinsic value.<\/p>\n\n\n\n

I seldom write down an estimate of intrinsic value, and I\u2019m not sure I\u2019ve ever<\/em>  attempted a DCF valuation of a company.  I think mainly in heuristic short-cuts: quick and dirty metrics like P\/E ratio, dividend yield, price\/sales, price\/net current assets, price\/net tangible assets, and so on.   Of course, P\/E ratios imply rates of capitalisation: if I think a P\/E of 12 is \u2018fair\u2019, I\u2019m saying intrinsic value is the company\u2019s current earnings capitalised in perpetuity at 8\u00bd% pa.  But in general, I don\u2019t find it helpful to make this transformation.<\/p>\n\n\n\n

There are several reasons why I find simple heuristics more useful than more rigorous analytics like DCF valuation.<\/p>\n\n\n\n

Time is precious<\/strong> There are more than 2,000 shares quoted on the London Stock Exchange and AIM.  Given the scope of the search space and the pace of change, DCF models simply take too long. <\/p>\n\n\n\n

If you need a calculator, it\u2019s too close<\/strong>  A good buying opportunity shouts at you from the market.  The cheapness should be striking enough that you can see it without detailed calculations.  If you need a calculator \u2013 let alone a spreadsheet \u2013 you should pass, because it\u2019s probably too close.<\/p>\n\n\n\n

Robustness matters more than refinement<\/strong> Investment is about finding valid<\/strong> discrepancies in a noisy-information environment.  Finding discrepancies is easy: there are always plenty of companies which appear to have extreme valuations.  But most of these discrepancies are not valid: the company deserves<\/strong> its extreme valuation.  When you think you’ve found something, searching for further independent<\/strong> insights which confirm or disconfirm the discrepancy is more useful than refining your estimate of its size.  <\/p>\n\n\n\n

In other words: when information quality is good, focus on quantifying and ranking your different options; when information quality is poor (as it usually is in investment), focus on raising information quality.\u00a0 (In a different but analogous context,\u00a0Givewell<\/a>\u00a0give an explicit Bayesian justification for this.)<\/p>\n\n\n\n

Non-financial heuristics are quicker\u00a0<\/strong>Sometimes heuristics such as\u00a0affinity<\/strong>\u00a0\u2013 the class of people associated with a company \u2013 can be a quick and sufficiently accurate route to correct decisions.\u00a0 For example,\u00a0J<\/a>ohn <\/a>Hempton<\/a>\u00a0suggests finding stocks to short based on a company\u2019s association with dodgy people, not dodgy fundamentals. He will short a stock (in very small quantity) based on association with one suspect promoter and one suspect lawyer,\u00a0without<\/em>\u00a0any investigation of the fundamentals.\u00a0 If the stock rises (ie moves against him), he investigates the fundamentals; if it goes down, he just takes the profits and moves on to the next one.<\/p>\n\n\n\n

The heuristic investor may make some mistakes the rigorous analyst does not make.  But the heuristic investor works much faster, and is able to evaluate many more opportunities. This is usually a good trade-off.<\/p>\n","protected":false},"excerpt":{"rendered":"

One criticism of the investors in Free Capital  which I have heard from more than one expert reader goes something like this: \u201cThe interviewees say they are making investment decisions, but none ever actually works out what a company is worth.\u201d  These readers then elaborate on the concept of intrinsic value \u2013 the discounted future cashflows (DCF) of the … Read more<\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[1],"tags":[],"class_list":["post-59","post","type-post","status-publish","format-standard","hentry","category-uncategorized"],"_links":{"self":[{"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/posts\/59","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/comments?post=59"}],"version-history":[{"count":1,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/posts\/59\/revisions"}],"predecessor-version":[{"id":60,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/posts\/59\/revisions\/60"}],"wp:attachment":[{"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/media?parent=59"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/categories?post=59"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.guythomas.org.uk\/blog\/wp-json\/wp\/v2\/tags?post=59"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}