Published on:7 June, 2019
We navigate day-to-day life, making decisions mostly based on our intuitive thinking, which is formed by years of experience in understanding and judging events. However, many important decisions in life, especially in investing, require thinking beyond the obvious, what is called System 2 thinking.
This summer, I went tiger sighting at one of India’s 50 odd Tiger Reserves. The mercury was breaching 45oC, but the safaris were fully booked, indicating the tiger’s popularity with enthusiasts and regular tourists alike. However, there was a short period of time in 2012, when tiger tourism had been banned by the Supreme Court, in response to a petition filed by an NGO. The contention was that tourism was detrimental to conservation efforts and keeping tourists away from the ‘core’ areas of the reserves will lead to improved habitats, and as a result, an increase in the tiger population.
There was also another school of thought which advocated the exact opposite. Since local populations depend on tourism for their livelihood, they are incentivised to not only preserve the forests, but also report activities such as poaching, illegal tree-cutting and so on. Tourism thus helps the tiger population thrive.
Matters of conservation aside, this episode highlights how we often mistakenly identify the cause of a problem. Sometimes, what appears at first glance to be the cause is a completely unrelated issue, could be just a symptom or in the case of tiger tourism, turn out to be a possible solution to the problem. And what seems like a possible solution could sometimes worsen the problem. Like banning liquor to prevent alcoholism drives people to seek spurious sources, leading to more serious health concerns. Or waiving farm loans to relieve agrarian distress worsens a famer’s access to credit in the long term.
It is therefore crucial to look beyond the obvious, so that the cause of a problem is correctly identified, and the right solution applied. The same principle works in the case of investing, but with the objective reversed – one is looking for opportunities rather than problems. We try to identify the core drivers of success as well as the root causes of failures of a business. While this seems so basic that it shouldn’t even warrant a mention by an asset management firm like ours, it is quite difficult in practice. And at Marcellus we constantly remind ourselves of the risks of falling into the trap of getting swayed by what seems obvious at first glance.
Daniel Kahneman, the Nobel prize winning psychologist describes this as System 1 and System 2 thinking. One is intuitive and the other, analytical. System 1 operates automatically and with practically no effort. For example, the answer to 2 + 2 would come to you in in instant. System 2 on the other hand requires some concentration and thinking. Consider this puzzle: A bat and ball together cost $1.1. The bat costs $1 more than the ball. How much does the ball cost? Kahneman’s (with Shane Frederick) research showed that most people tend to use System 1 thinking and answer that the ball costs 10 cents, which is wrong. A little effort (System 2 thinking) yields the correct answer.
We make decisions most of the times intuitively, and it has little consequence on the outcome. However, in managing investments, we need to frequently call upon our System 2 thinking. A civil EPC company reporting a consistent increase in operating margins should be a positive indicator to buy the stock, right? But how much of the margin expansion is due to aggressive revenue recognition or from liberal credit terms granted to customers? A commodity producer sees profitability improve despite a fall in volumes. How much of it is explained by better realisations (the obvious) and how much by the reduced volumes leading to a higher proportion of relatively lower-cost captive raw material consumed (the not-so-obvious)?
Of the many ways in which we, at Marcellus try and avoid some of the traps in identifying success factors of a business, is constantly questioning ourselves as, well as colleagues, for all stock ideas under research. Our portfolio counsellors face a barrage of Whys, Hows and Whats in every team meeting, forcing all of us to collectively uncover, layer by layer, the secret sauce of a potential portfolio stock. A stock discussion in our research meeting could go like this:
Colleague A: General Insurance Company XYZ will earn RoE in excess of n% over the next 5 years
Colleague B: Why?
A: Because their combined ratio will go below 100% and investment yields will sustain at 9%
C: Why will combined ratio improve?
A: They have an experienced underwriting team and strong risk selection processes
D: What is strong about the risk selection process?
A: They use extensive data analytics to price risks and the sales team is penalised for poor underwriting experience, which incentivises them to select customers carefully
B: What are the examples of use of data analytics and evidence of how it has helped in avoiding risks
…these discussions thus go on till the team is convinced of the fundamental drivers of a company’s performance.
Identifying the root cause of a company’s performance is thus the first important step in our investment analysis. The second, and equally important step is to understand whether the drivers of performance can be sustained over the long term or not – what is a defensible moat or an enduring competitive advantage? An IT company has been consistently growing profits and let’s say we identify its industry-leading attrition rate as one of the reasons for its success. We are then interested in knowing what in its HR policies helps keep employee retention at such high levels. And then, what is it that competitors cannot do to achieve the same level of success in retaining people.
The task of finding the core drivers of success and their sustainability is especially challenging for companies that are already successful. For example, in trying to identify the root cause of the low attrition of the same IT company mentioned above, we may seek feedback from employees or external HR consultants or competitors. The answers we’ll probably get are ‘we have an employee friendly culture’, ‘the company helps maintain work-life balance’, ‘management cares for people’, ‘best learning and training policies in the industry’ and so on. How should one interpret this feedback? Is the company offering the best training in the industry as an employee retention tool, which in turn is driving profits? Or that the company can afford to offer high quality training because it is so profitable? And if profits slow or decline in the future, will training budgets get cut? The same goes for culture – a bank’s culture of pursuing aggressive growth is admired when profits are rising. But when NPAs also rise, the same aggression is blamed for the downfall.
Phil Rosenzweig captures these issues brilliantly in his book, ‘The Halo Effect’. He says, “Successful companies will almost always be described in terms of a clear strategy, good organization, strong corporate culture, and customer focus. But whether these things drive company performance, or whether they’re mainly attributions based on performance, is a different matter.”
While our research process is much more extensive and covers more ground than explained above, we always start with the two essential steps – first, knowing what the key to success is, and then understanding if it can be replicated by others or not. Most often, the answers to these questions set us on the path to uncovering the enduring competitive advantage (or the lack of it) of a business and then eventually, the decision to hold it in our portfolios.
So, while we go back to pondering more on potential investment ideas, we would urge you to contemplate taking your next holiday in the wild and help save some tigers!
Salil Desai is a Portfolio Counsellor at Marcellus Investment Managers.
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