Long read: Conviction and Quality

This is an insightful essay by a hedge fund manager on how there are two sources of conviction – explicit and implicit, and how we need a combination of both. Explicit conviction that’s backed by analysis and implicit conviction which is more intuitive (much needed when all analysis fails).

“In the context of investing, one might develop the thesis that a particular company can capture X% market share, generate Y dollars in annual revenue, achieve Z% operating margins, and therefore has an intrinsic value within a certain range. One might have high confidence because of the presence of competitive advantages and management with a very good track record. One would have a range of expected returns from owning the shares over time. All of this would fall into the explicit category.

Sooner or later, the investment would encounter a confounding surprise. Perhaps execution turns choppy, a new competitive vector emerges out of nowhere, an exogenous crisis turns the world upside down, etc. Old projections are now in doubt, previous plans and strategies are being reworked, everything is less fun. These things are actually happening all the time— something explicit conviction has a way of tuning out! Only genuine and well-placed implicit conviction, a qualitative knowing that the company will do what it needs to and ought to do, is equipped to ably traverse this kind of terrain. Unlike analysis-based explicit conviction, implicit conviction comes from something deeper than the cause and effect we perceive in the unfolding of events—it is both analytical and, crucially, intuitive (about which more later).

It is fascinating that the two convictions often exist in tension. For example, early in my career I commonly experienced tension when faced with a bargain price (explicit) for a company I did not particularly admire (implicit). One of my most challenging investments involved an impairment of trust (implicit) coupled with a lower valuation multiple owing to a falling share price (explicit). My best investments have erred on the side of management and cultural excellence (implicit) when faced with disappointing fundamental performance or a seemingly stretched valuation (explicit)”

The author goes on to share how even Buffett and Graham have shared their experiences where implicit and explicit convictions are at play.

In the second part of the essay, he double clicks on implicit conviction and links it to the appreciation of quality in the underlying business. Incidentally, the author attributes his appreciation of quality to Robert Pirsig, the author of the book “Zen and the Art of Motorcycle Maintenance”, the book that also inspired Nomad Partnership’s Nick Sleep to look for quality in businesses.

The author starts with a few markers of quality in businesses:

“Well-honed intuition does what analysis cannot by perceiving Quality directly, as opposed to through an intellectual process. What I suspect is happening in the direct perception of Quality is subconscious pattern recognition, based upon a dynamic, holistic experience of the thing in question. Of course, the ability to intuitively recognize patterns in a specific domain must be earned through experience and feedback; indeed, I have found that the value of my own intuition has grown (starting at zero) over many years. Interestingly, I also find that experiencing Quality in any one domain (e.g., music or meditation, to use examples that are dear to me) can be helpful for recognizing it in other domains (including business) because Quality’s nature is universal, even as its manifestations are necessarily particular.

I believe that the analytical vantage point and the intuitive vantage point are profoundly complementary, together providing a far deeper and more complete picture than either on its own. My process for getting to know companies involves endlessly iterating between the two. Using two lenses instead of one tends ultimately to winnow out investment options, narrowing the field to companies that pass both tests”

The essay is well worth a read in its entirety as the application of conviction and quality go beyond the realms of investing.