Friday, April 12, 2013

The Pareto Principle and Investing

The Pareto Principle states that 80% of the results, outputs, or rewards, are generated from only 20% of the causing inputs or efforts.

The implications for investing:

1. 20% of our best stocks will probably generate 80% of our overall profit.
2. 20% of the time we spent doing research usually generates the 80% most useful information.
3. 80% of the time we spent doing research is likely not very productive.

The above implications can be very  discouraging for investors who have never thought about applying the Pareto Principle to their investment research. In fact, I wrote this article because I was truly disappointed and bothered by the feeling that most of my time spent doing fundamental analysis is not targeting the most important things. Why? Because I often forget to write out the most important thing first before I even start my research. This article is trying to address implication 2 and 3 above.

 My investment research routine is

1. Research company background, read the most recent 3-5 10Ks and 10Qs of the company and those of its competitors to answer every question on my checklist.
2. Gather 10 years of financial statements and build the valuation model.
3. Calculate intrinsic value and  margin of safety.

I usually spent about 90% of the time performing step 1 and step 2 above. The intrinsic value and margin of safety calculation are the most important things but it usually takes about 10% of my time. Well, you can argue that step 1 and step 2 above are necessary as they build the foundation for step 3 but step 1 and step 2 frequently incorporate a lot of assumptions and each one of them may impact the ultimate result in step 3. Garbage in and garbage out. The majority of the information I gather in step 1 and step 2 end up being inconsequential. Therefore,  it's not the quantity of time you spend that will ultimately determine the quality of your research, it's the quantity of time you spend addressing the most important things that really matter.

Here is a most recent example. I have been digging into the for-profit education sector and have spent a massive amount of time just to gather all the financial data and incorporate them into the valuation model. I've also read the 10Ks for Strayer Education, Apollo, Capella and Career Education. However, just like someone driving around in a strange city without navigation, I wondered around for a while, lost and still not getting to the point. I read all the business description, all the risk factors and the regulatory environment but still have not put all the piecemeal information together in a meaningful way because I have already spent so much time and I feel justified to delay the ultimate intrinsic value calculation. To quote Michael Bauboussin "Most people do not find it natural to match ideas from their mental database to tricky situations in the real world. Our brains are not wired for the process of moving from preparation to recognition. Indeed, typical decision makers allocate only 25% of their time to thinking about the problem properly and learning from experience. Most spend their time gathering information, which feels like progress and appears diligent to superiors. But information without context is falsely empowering. if you do not properly understand the challenges involved in your decision, this data will offer nothing to improve the accuracy of the decision and actually may create misplaced confidence. "

He is exactly right. In doing fundamental research, we often gather information for the sake of gathering information, which feels like progress and create misplaced confidence because we tell ourselves that we spent a lot of time doing research and therefore, we should have confidence in our thesis. This fallacy is very dangerous, especially in the world of investing yet so many of us have been ignorant to it. In my opinion, the best way to cope with this is to begin our investment process by asking ourselves what are the most important things.

With regards to the for-profit education sector, the most important things are:

I.  How likely is an institution not in compliance with the regulation and can the institution go out of business if not in compliance?  Specifically, what is the institution's compliance status with regards to:

  • Cohort Default Rate
  • The 90/10 Rule
  • Incentive Compensation
  • Gainful Employment
  1.  At least 35% of students are in satisfactory repayment status with respect to their federal student loans three to four years after entering repayments. 
  2. If the annual loan payment of a typical graduate of the program for all debt incurred by the graduate for the program does not exceed 30% of the average or median discretionary income in the third or fourth year after graduation; or
  3. If the annual loan payment of a typical graduate of the program for all debt incurred by the graduate for the program does not exceed 12% of the average or median annual earnings in the third or fourth year after graduation; 
II. Is the headwind that the for-profit education sector facing structural issue or cyclical issue?

III. If the headwind is a cyclical issue, what will enrollment level be once things return to normal?

IV.What strategies are being executed to address both the current headwind and future development?

V. Given I-IV, what is the intrinsic value of the business?

I am absolutely not indicating we should abandon hardcore fundamental analysis. Diligent fundamental analysis is what defines value investors. What I am suggesting in this article is that before we start our research, we should take the time to define our focus points in our research. Once we lay out the most important things, we can direct our research to address them first. Once we've answered all these vital questions, we can dive into other things.Warren Buffett once said: The chain of habit is too light to be felt until it's too heavy to be broken. The habits we cultivated as teenagers inevitably affect how to behave as adults. In investing, in order to not lose money and generate superior return, we have to be cognizant of the habits we cultivated when we were young that could inherently lower the quality of our research and hence, the potential return of our investment. It takes time and can be against human nature to step back and question ourselves but that's how we become better over time.

By the way, here are two  much better articles on similar topic from Geoff Gannon.

As always, I welcome all constructive criticism.

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