05-01-2014, 01:20 AM
(This post was last modified: 05-01-2014, 01:24 AM by earthtodan.)
I see this stated sometimes as a prerequisite for great investing, and frankly it sounds a bit fanciful. I don't think it's possible to separate emotion from investing, or from anything else we do in life.
I can rationally analyze a stock all day, but the next morning when I wake up, when I think of the company - say I see the name JNJ while reading an article - it flashes through my mind as a split-second emotional reduction of the conclusions I've drawn. In that 1/1000th of a second there is only time for me to remember my degree of "like!" In other words, I don't think of JNJ rationally, but rather with an emotional reference point.
That subjective impression may be arrived at by objective means and rules, but there are some circumstances that cannot be quantified objectively. For example:
- There is value in a dividend aristocrat. Colgate-Palmolive has increased its dividend at a healthy rate for 51 consecutive years. What is the rational value of this history? It has to be valued subjectively. On a pure metrics basis, a modern tech stock like Intuit actually looks better. CL has a fairly high payout ratio, high debt load, and single digit projected EPS growth. INTU has low debt, a lower payout ratio by half, double digit projected EPS growth, huge margins, a sticky product, a lower valuation, and a stated shareholder return policy. However INTU has almost no dividend history. Which is the better choice as a DG stock? It takes a subjective decision to go with CL.
- What is the value of a moat? Union Pacific has an extensive railroad network across the US that can't be easily replicated. What's the rational value of this defensive quality for UNP? According to Morningstar, it's "wide." Objectively speaking, how much is a wide moat worth to your portfolio allocation of UNP? You can have a rule around this, but you'll have to make it up first.
- I am long WFM (by way of being short a put) and own shares of their main distributor UNFI. From a hard and fast dividend history perspective, these are suspect investments. UNFI doesn't pay a dividend or return cash to shareholders in any way. However when I look at them from a revenue growth and total return perspective, they look attractive, and my emotional conviction that there is a secular trend toward healthy eating seals the deal. I can't place a value on this secular trend, yet it is real and has powered their returns so far. My emotional convictions and subjective impressions of the world are a factor in these investments, in tandem with all the standard metrics.
- How do you place a value on a patent cliff? You certainly can't use historical metrics, because the approval of a pharmaceutical pipeline is entirely forward-looking, and even speculative. But should that stop you from investing in big pharma?
As an interesting tangent, there was an episode of Radiolab where they told the story of a man who had a brain tumor removed, and unfortunately his emotional center was surgically removed along with it. He returned to his family and his job perfectly intact in terms of his rational abilities, memories, and intelligence, yet he was strangely dysfunctional. He would sit at his desk at work, staring for half an hour at a contract that had to be signed, unable to decide whether to pick up the black pen or the blue pen to sign it. It turns out that emotions are central in making hundreds of seemingly inconsequential decisions throughout the day. There is no rational way to decide between using the blue or the black pen; however, a split second non-rational decision allows most of us to pick up one or the other, and keep moving.
There are probably no two securities as substantially identical as a black pen and a blue pen that could paralyze our rational analysis. However there is plenty of uncertainty that requires us to apply judgment and conviction.
I can rationally analyze a stock all day, but the next morning when I wake up, when I think of the company - say I see the name JNJ while reading an article - it flashes through my mind as a split-second emotional reduction of the conclusions I've drawn. In that 1/1000th of a second there is only time for me to remember my degree of "like!" In other words, I don't think of JNJ rationally, but rather with an emotional reference point.
That subjective impression may be arrived at by objective means and rules, but there are some circumstances that cannot be quantified objectively. For example:
- There is value in a dividend aristocrat. Colgate-Palmolive has increased its dividend at a healthy rate for 51 consecutive years. What is the rational value of this history? It has to be valued subjectively. On a pure metrics basis, a modern tech stock like Intuit actually looks better. CL has a fairly high payout ratio, high debt load, and single digit projected EPS growth. INTU has low debt, a lower payout ratio by half, double digit projected EPS growth, huge margins, a sticky product, a lower valuation, and a stated shareholder return policy. However INTU has almost no dividend history. Which is the better choice as a DG stock? It takes a subjective decision to go with CL.
- What is the value of a moat? Union Pacific has an extensive railroad network across the US that can't be easily replicated. What's the rational value of this defensive quality for UNP? According to Morningstar, it's "wide." Objectively speaking, how much is a wide moat worth to your portfolio allocation of UNP? You can have a rule around this, but you'll have to make it up first.
- I am long WFM (by way of being short a put) and own shares of their main distributor UNFI. From a hard and fast dividend history perspective, these are suspect investments. UNFI doesn't pay a dividend or return cash to shareholders in any way. However when I look at them from a revenue growth and total return perspective, they look attractive, and my emotional conviction that there is a secular trend toward healthy eating seals the deal. I can't place a value on this secular trend, yet it is real and has powered their returns so far. My emotional convictions and subjective impressions of the world are a factor in these investments, in tandem with all the standard metrics.
- How do you place a value on a patent cliff? You certainly can't use historical metrics, because the approval of a pharmaceutical pipeline is entirely forward-looking, and even speculative. But should that stop you from investing in big pharma?
As an interesting tangent, there was an episode of Radiolab where they told the story of a man who had a brain tumor removed, and unfortunately his emotional center was surgically removed along with it. He returned to his family and his job perfectly intact in terms of his rational abilities, memories, and intelligence, yet he was strangely dysfunctional. He would sit at his desk at work, staring for half an hour at a contract that had to be signed, unable to decide whether to pick up the black pen or the blue pen to sign it. It turns out that emotions are central in making hundreds of seemingly inconsequential decisions throughout the day. There is no rational way to decide between using the blue or the black pen; however, a split second non-rational decision allows most of us to pick up one or the other, and keep moving.
There are probably no two securities as substantially identical as a black pen and a blue pen that could paralyze our rational analysis. However there is plenty of uncertainty that requires us to apply judgment and conviction.