You learn from hindsight and get paid for foresight. Often times an opportunity exists because the conditions aren’t perfect yet. You have to pull the trigger in advance of all the pieces coming together. Investment success is determined by two things:
- How well you assimilate imperfect information
- Your ability to identify when you are wrong quicker
I love this quote. It’s the perfect description of microcap investing:
“Most decisions should probably be made with somewhere around 70% of the information you wish you had. If you wait for 90%, in most cases, you’re probably being slow. Plus, either way, you need to be good at quickly recognizing and correcting bad decisions. If you’re good at course correcting, being wrong may be less costly than you think, whereas being slow is going to be expensive for sure.”– Jeff Bezos
The price of certainty is expensive because it slows you down. We want to know everything. If I just knew a little more. A little more. A little more. But knowing more often times breeds confidence but not accuracy.
In 1974, Paul Slovic — a world-class psychologist, and a peer of Nobel laureate Daniel Kahneman — decided to evaluate the effect of information on decision-making. This study should be taught at every business school in the country. Slovic gathered eight professional horse handicappers and announced, “I want to see how well you predict the winners of horse races.” Now, these handicappers were all seasoned professionals who made their livings solely on their gambling skills.
Slovic told them the test would consist of predicting 40 horse races in four consecutive rounds. In the first round, each gambler would be given the five pieces of information he wanted on each horse, which would vary from handicapper to handicapper. One handicapper might want the years of experience the jockey had as one of his top five variables, while another might not care about that at all but want the fastest speed any given horse had achieved in the past year, or whatever.
Finally, in addition to asking the handicappers to predict the winner of each race, he asked each one also to state how confident he was in his prediction. Now, as it turns out, there were an average of ten horses in each race, so we would expect by blind chance — random guessing — each handicapper would be right 10 percent of the time, and that their confidence with a blind guess to be 10 percent.
So in round one, with just five pieces of information, the handicappers were 17 percent accurate, which is pretty good, 70 percent better than the 10 percent chance they started with when given zero pieces of information. And interestingly, their confidence was 19 percent — almost exactly as confident as they should have been. They were 17 percent accurate and 19 percent confident in their predictions.
In round two, they were given ten pieces of information. In round three, 20 pieces of information. And in the fourth and final round, 40 pieces of information. That’s a whole lot more than the five pieces of information they started with. Surprisingly, their accuracy had flatlined at 17 percent; they were no more accurate with the additional 35 pieces of information. Unfortunately, their confidence nearly doubled — to 34 percent! So the additional information made them no more accurate but a whole lot more confident. Which would have led them to increase the size of their bets and lose money as a result.
How can we apply this to investing? How do you focus on what is important? What is signal? What is noise? Just like the experienced horse betters, the more experience you gain the better you get at knowing what you are looking for and sizing up a situation quickly.
I think if Bezos would have continued his quote he would have said focus on the 70% that matters and be okay if the 30% you don’t know hurts you. You have to live with the possibility that you could be wrong. You can’t let the fear of the 30% steal your courage to move forward if you believe the odds are in your favor.
I’m reminded of this beautiful quote from Billy Beane about why Lenny Dykstra was a better baseball player than him, “He was able to instantly forget any failure and draw strength from every success. He had no concept of failure. And I was the opposite.”
Your goal should be to make as few buy decisions as possible but making few decisions doesn’t mean making slow decisions. In microcap, an opportunity may only exist for a short window before others discover it and push the price to levels where it is no longer attractive. Speed is important.
How can you be both quick and accurate? I apply these four filters to every new company I evaluate:
- An organization with signs of intelligent fanaticism
- A business that can grow through a recession
- A balance sheet that can weather a storm and act with occasional boldness
- A stock that can conservatively double in 3 years
When I apply these four filters I might miss something, but it cuts to the core of what is important. I can normally size up a new opportunity that I’m attracted to in a few hours. Over the years I’ve found being quick has served me better than being slow. If it takes a long-time to get to a buy decision then it probably isn’t a buy. The great opportunities are normally obvious, at least to you.
The greater the margin of safety the quicker you can pull the trigger. As Warren Buffett said, “Price is my due diligence”. Price always matters, and when you pull the trigger quick it should matter more.
In addition, I’ve found buying small and averaging up later as you gain additional conviction is a great way to counterbalance being fast and right with the risk of being fast and wrong. You aren’t going to be right all the time, but try to be wrong as fast as you can and move on.
“Be willing to make decisions. That’s the most important quality in a good leader. Don’t fall victim to what I call the “ready-aim-aim-aim-aim” syndrome. You must be willing to fire.”– T. Boone Pickens
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