Fact-based vs. Opinion-based Investing – August 2017

Fact-based vs. opinion-based investing

“When my information changes, I alter my conclusions. What do you do, sir?” – John Maynard Keynes

One of the hardest and most profitable skills to develop as an investor is the ability to be open to new information and to change one’s mind when new information alters one’s previous conclusions. At Somar we have improved our returns by leveraging new information to change long positions into shorts and short positions into longs. To develop this skill, we had to overcome 3 barriers:

  • Confirmation bias
  • Commitment and consistency bias
  • Ego

Confirmation bias is the tendency to look only for information that confirms one’s conclusion and to ignore other information as “noise”. Confirmation bias closes our mind to alternative explanations for the available facts. This effect gets stronger for emotionally charged issues and for deeply entrenched beliefs1.

  • To avoid this, at Somar we proactively use our primary research and data science projects to look for any information that might disprove our investment thesis. Somar also proactively looks to understand in depth the investment thesis of investors with opinions contrary to our own.
    Commitment and consistency bias is our desire to be (and appear) consistent with our previous choices and actions. After taking a public action or stand, we face very strong personal and social pressure to stay the course even in the face of new and adverse facts and information2. This bias makes it extremely hard for investors who have publicly written about a position or presented an investment thesis to change their minds in the face of new information.

At Somar we avoid writing and presenting about existing positions. We wait until we harvest our investments to go public about them.

Ego exacerbates the two previous biases. The larger the ego, the more entrenched the investor will be in his
opinions and public standing and therefore the more resistant he will be to change his mind. Paraphrasing
Max Planck: “Science advances one funeral at a time”3.

  • At Somar we take a mission approach to investing. Our mission is to scour the world for the most
    compelling risk-reward opportunities to put your capital to work. We don’t let anything get in the
    way of us achieving that mission, including each team member’s ego. Humility is a core value at
    Somar4.
    Over the past months, we have found thesis-disproving information for a few of our positions and acted
    accordingly. On some of them, the implication of the new information was large enough to make us switch
    sides between long and short.
    To illustrate, we had a short position on a food restaurant delivery aggregator5. Our thesis included the
    following points:
  • Increasing competition – our talent flow analysis identified Amazon and Uber building teams to enter
    the market. Other VC funded new ventures were entering the space.
  • High margins that appeared to be unsustainable given the growing competition.
  • Valuation that didn’t reflect either margin erosion or loss of market share.
    We put the short position on and new competition did materialize as expected. However, our primary
    research on its effects, including competitor and customer interviews, uncovered the following facts:
  • New competitors were unsuccessful in stealing existing customers from the incumbent. Once a
    customer is using an app to order food from his favorite restaurants, he has no incentive to switch
    provided there are no service glitches.
  • Competition also had no impact on the rates that restaurants paid to the incumbent aggregator.
  • The incumbent, being the larger player, benefits from strong network economies: the more
    customers it gets, the more orders it sells for restaurants which in turn attracts new restaurants to
    join the marketplace; and the more restaurants join the marketplace, the more attractive it becomes
    to customers, leading existing customers to order more frequently (given wider range of food
    options) and new customers to join the platform.
  • The incumbent also benefitted from scale economies in advertising which significantly lowered its
    customer acquisition cost and creates an additional barrier to success of the new competitors.

We reassessed the cash generation potential of the company and concluded that its current valuation was actually quite attractive. We covered our short and then we built a long position.

 

1 For more information please start at https://en.wikipedia.org/wiki/Confirmation_bias

For a deeper analysis of this bias please read “Influence: The Psychology of Persuasion” by Robert Cialdini

3 The original quote from Max Planck is: “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.”

4 Our three core values are: Honesty, Humility and Hunger. For a copy of our culture statement please e-mail Colin at
colin.butler@somarcap.com

5 You will notice we don’t reveal the names here to avoid commitment and consistency bias.

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