The epistemology of value investing

A reflection on the value method.

Read a lot and watch out the window

This article is a reflection on what makes value investing special. 

Specifically, I believe the core value tenets derive from a specific epistemology, i.e., what can be known and how to learn it. This epistemology is based on the belief that our rationality is limited and that humans form complex systems that are difficult to analyze effectively with deterministic methods.

Focusing on companies while ignoring prices, enshrining curiosity and voracious reading, and having a flexible mind that can work with both breadth and detail are ways of finding valuable knowledge in a complex world.

TLDR:

• Value investing differentiates itself from other investing approaches by an orthodox disregard of prices. This seems odd, given that prices are the most salient characteristic of financial markets. That rejection reveals a lot about value’s view of the world. 

• The value epistemology is based on two tenets

  • The human mind has limited information processing capacity and absorbs reality through the lens of perception.

  • Human systems are complex in the sense that they have almost infinite features and volatile relationships between these features.

• The value investor approach helps operate (profitably) in this complex world.

  • Avoid the excessive and useless complexity introduced by prices.

  • Broaden the universe of features used to evaluate companies.

  • Embrace heuristics and partial theories. Make use of several models to explain the same reality. 

  • Allow space for intuition and hunch. 

  • Cultivate an intense curiosity.

Prices or companies, the value schism

One big schism in the investing practice is between those who think we can learn something about the future of prices and those who believe we can’t.

A market technician, for example, thinks that by studying technical patterns, we can speculate where prices are more likely to move. A quant believes that by studying the statistics of securities prices, we can speculate on how prices will behave.

On the other hand, many investors believe that security prices are almost random in the short to mid-term and that only in the long term do they follow some weak form of their intrinsic value. This would be the fundamental camp.

Among them, the Taliban of the ‘prices are an unknown’ camp are the value investors.

The true investor will do better if he forgets about the stock market and pays attention to his dividend returns and to the operation results of his companies
Benjamin Graham

I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for ten year
Warren Buffett

Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result.
Charlie Munger

Often, there is no correlation between the success of a company's operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.
Peter Lynch

In the most orthodox value creed, investors should buy without expecting to sell their shares. Rather, they derive all of their return solely from the business' distributed profits (dividends), which depend on returns on capital and reinvestment rates.

This is the idea behind the coffee can investment method (buy stocks only to hold them for 10 or 20 years) or Buffett’s farm analogy.

The epistemological position of value

But rejecting prices seems odd, given that they are the basis of financial markets. The flashing lights of the exchange and the sharp curves of the chart are the image of investing. 

This reject is explained by a specific epistemological position, different from other camps of investing. At the core is the belief that human dynamics are highly complex and that our rationality is limited. 

In this section, I explain those two beliefs in more detail.

Bounded rationality and perception

The value school generally believes humans are not very good at processing information. Human cognition is biased and limited. This contrasts with a big part of economic and financial theory, which forms the basis of some forms of passive and quant investing.

Humans also perceive and act on the same facts differently. We are heavily influenced by our circumstances. We don’t follow an instructions manual.Therefore, forecasting how people will react to a situation is difficult.

This leads value investors to avoid forecasting things that depend excessively on others’ subjectivity. For example, a company whose product is a necessity and does not have many substitutes is much more desirable than a fashion product. We need to estimate less things about people’s behavior.

Further, some perceptions are more volatile than others. Market perceptions and moods are notoriously volatile. This was exemplified in Graham’s Mr. Market.

Complexity

Human systems are complex. This means that there are almost infinite variables interacting in a mutating fashion. Complex systems are difficult to treat with all-encompassing theories and functions and are difficult to describe with words.

Value investors are, therefore, skeptical of formulaic approaches. They prefer heuristics. A generally leads to B, but only under C, D, and E.

Richard Bookstaber describes three characteristics of complex systems, such as the economy, companies, and the market that make them particularly unwieldy for deterministic treatment.

• Perception loops

We act not only because of what others do but also because of what we think they will do. Keynes exemplifies this in his beauty contest.

"It is not a case of choosing those [faces] that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be."
J.M. Keynes

This problem is pronounced for market technicians. Everyone believes that $100 is a resistance, but then everyone will sell at $99, which becomes the resistance, then at $98, and so on.

More generally, this problem also appears when predicting what is ‘priced in’. We speculate that the oil supply will be tighter, but now we need to speculate on how much others know about it while they are doing the same.

Anything you can think of has already been priced in, even the things you aren't thinking of. You have no original thoughts. Your consciousness is just an illusion, a product of the omniscent market. Free will is a myth. The market sees all, knows all and will be there from the beginning of time until the end of the universe (the market has already priced in the heat death of the universe).
zsd99 - r/wallstreetbets

• Emergent properties

Systems are themselves parts of other systems, like a Russian doll. The different levels of this hierarchy interact. The interactions are emergent properties because they don’t belong to the original components. Therefore, things cannot be explained without also explaining the systems to which they belong.

An example is a company’s competitive position. Companies in the abstract don’t have a position; they have it only inside a market, which is their system. Therefore, to describe a part of a company (its competitive position), we need to describe its parent (the market to which it belongs). In turn, we need the company to explain the market. Again, a loop.

Just like perception loops, the emergent properties of systems multiply the number of variables and interrelations. Relations between two variables depend on many others, making them less stable.

• Non-ergodicity

The most basic example of probability is the dice. If you roll it a lot, each face will have the same frequency probability. This is the basis of the fundamental financial concept of expected value.

When we use stable means and deviations in financial theory, we assume ergodicity. The portfolio has a mean return of 10% and a standard deviation of 15%, but that distribution will only materialize if returns from many years with similar characteristics are accumulated.

The difference in a non-ergodic system is that the dice are rolled only once, and the same game is never repeated.

Would you play Russian roulette for any amount of money? Probably not, and the reason is that Russian roulette is very non-ergodic. The probability of making it alive is high, but the game stops if you get the bullet.

In investing, non-ergodicity is not so fatal but still omnipresent. Two sets of situations are never exactly equal, so no game is played twice under the same conditions. 

The value method

What can we do if the world is such that relations between variables are volatile and nothing can be known with absolute certainty? Is investing simply random, and is there no way to do it better?

The value method allows us to navigate such a complex world. I think five ideas summarize the main principles behind it.  

Ignore prices

Back to prices, value investing rejects them because they add too much useless complexity.

Everything has complexity, but prices even more. First, they collapse all the vastness of information into a single variable, making the cumulative volatility enormous. Second, the amount of parameters involved grows exponentially via perception loops. That extra complexity is useless because the perceptions and events that mold prices are fleeting.

That is why focusing on company operations is a better use of our time. The dynamics of company performance are very complex, too, but they are less complex than prices. Further, fundamental information tends to change less often.

Unfortunately, most self-considered value investors, knowingly or not, introduce some form of price forecasting in their investment decisions. For example, an expected terminal multiple on earnings is a price forecast. We expect someone will pay a price for each $1 of earnings. Inverted, the terminal return on equity used to discount cash flows is also a price forecast. In this case, the return is just the earnings yield (or the inverse of the multiple). The famous catalysts are a perception forecast.

Embrace heuristics and partial theories

Value deals with complexity by embracing individuality and nuance. Whereas other treatments of the world try to reduce it to components and rules, value investors prefer the details that make things different.

For example, if company A is in the apparel business, we can start with the theory that its market is competitive. But then, we will go deeper to find information that confirms or rejects that idea. We will look for complementary theories that explain when apparel companies face less competition, etc.

It is not a rejection of theory but the concurrent use of many theories depending on occasion. Instead of embracing one way of thinking, value investors compare competing theories to make the best use of each.

You need a different checklist and different mental models for different companies. I can never make it easy by saying, 'Here are three things.' You have to derive it yourself to ingrain it in your head for the rest of your life.
Charlie Munger

Expand the features, particularly qualitative

Value investors go outside the financial statements and even the 10-K to find more detailed data to draw relations. 

By acquiring a lot of information from many sources, from philosophy treaties to trucker trade magazines, value investors expand the matrix with which they approach the world. Because they work without tight formal models, value investors can give more weight to different types of evidence for different companies. The treatment does not need to be consistent.

In particular, qualitative information should be given a lot of attention. It is difficult to write formulas that relate qualitative variables, but the relations they indicate might be solid anyways. 

For example, while reading an earnings call, the investor might notice a detail that tips him off about the company's culture. Say the CEO mentions that ‘growth is our number one priority.' This becomes an important data point for this company in particular. 

Give space to intuition

Because value analysis does not use formal models, sometimes the conclusions cannot be explained entirely rationally. This is not a sign of intellectual laziness or sloppy thinking but rather the result of working with a complex reality using ad-hoc variables.

Like in the previous example from a CEO obsessed with growth, sometimes a single observation will be given extreme importance. This is not incorrect because that observation might be the resultant of a lot of background interactions that are inferred from the observation. 

In this respect, the way the subconscious works is important. Everything we observe is processed by the mind, stored, and related to other things we know. The mind then becomes good at recognizing patterns, even when we are not aware of why they exist. These are intuitions, things that stand out when we read a report or financial statement. We cannot explain why we think it's odd; it just is. 

Other human cognition processes work like this: repetition creates brain patterns stronger than rules. One example is language (and similarly how LLMs work), and another is chess or go.

Cultivate an intense curiosity and read voraciously

At the center of the method is an insatiable curiosity fed by voracious and broad reading.

In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time -- none, zero. You'd be amazed at how much Warren reads--and at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out.
Charlie Munger

The person that turns over the most rocks wins the game. And that’s always been my philosophy.
Peter Lynch

Reading is necessary because it provides us with more detailed heuristics and partial models to work with. It also helps us solidify the connections between qualitative variables that lead to intuition. 

Even though reading is not the only way to do this, it is one of the most efficient, especially if we can find good quality information (like information-rich books or reports). Still, listening to podcasts or talking to people is also valuable. 

You’ve got to have models in your head and you’ve got to array you experience – both vicarious and direct – onto this latticework of mental models.
Charlie Munger

The hard part

I think the method explained above is useful, and seems more adapted to the epistemological reality of investing, but I also acknowledge it is challenging to implement.

For most investors in an institutional setting, ignoring price dynamics is impossible. Their stakeholders would not allow it. This is an advantage of small investors, as explained by Peter Lynch, but even when allowed to wait, prices not moving in one’s direction can be nerve-wrenching.

Also, not finding immediate use for the information processed can generate anxiety. Most of the time, the information is not directly applicable to an investment thesis. It just sits on the brain, compounding the mental models. Carrying this process for months and years can be unsettling without monastic patience. 

A similar problem is that most investment opportunities will go to ‘pass,’ not because they are not good, but because conviction is not high enough. Errors of omission will mount. 

Finally, the above process does not eliminate the biases. In fact, given that it is not formal and sometimes not even explicit (working like a black box), it may compound them. The process requires even more second-guessing and reviews, plus an open mind that is slow at jumping to conclusions (especially when leading to action) and actively seeks contradictory information. 

However, there is something about hardness, and truth is attractive. Call me a romantic, but I like the idea of someone cracking the code by following the tortoise instead of the hare.

Yet, it makes sense that the process that leads to investment success is complicated and requires years of persistence to master. Otherwise, it would be arbitraged out. 

Thank you for reading, and have a great week. As always, feedback is the best reward I can get from you.