A Small Trick to Know if Your Favourite Stock Will Live or Die
Popeye must be the weirdest and most endearing cartoon character of all time.
Even the choice of spinach as his miracle diet is peculiar. Why choose a leafy green vegetable over the hundreds of other options available? Was the creator himself extremely fond of spinach? Or was it to promote healthy eating amongst children and teenagers?
It was only when I came across an old article from the Wall Street Journal did I realise the real reason...
Turns out, a chemist who analyzed the iron content of green vegetables accidentally misplaced a decimal point while noting down the data.
As a result, spinach was reported to contain a tremendous amount of iron - 35 milligrams per serving, instead of 3.5 milligrams.
This distorted fact about the nutritional power of spinach then passed down as knowledge... And pushed studio executives to use spinach as Popeye's wonder food.
By the time the error was noticed, Popeye and his spinach had already become the stuff of legend. It was too late to tinker with the most potent weapon in his armory.
Here Comes the Fact - O - Meter
Samuel Arbesman has used this example in his delightfully nerdy book, The Half Life of Facts, to drive home an important point.
Facts change. And not change only because of clerical goof-ups - like in the case of spinach. They change because they have a limited shelf life.
Even facts we think are immutable, eventually meet their end and are replaced by new ones.
To put it differently, knowledge, or the entire collection of what we know as 'accepted facts', is far less fixed than we think it is.
It is not as if we don't know that some facts do change. But according to Arbesman, when thinking about knowledge, people only think of two kinds of facts: facts that don't change, like the height of Mount Everest or the capital of United States; and facts that change constantly, like the daily temperature or the stock market closing.
However, there's a third category that can be best described with the help of the following examples.
While I was growing up, I was taught that there were 25 states in India. The number has since moved to 29. Similarly, if you studied chemistry in the 70s, you wouldn't know that 12 new elements have been added to the periodic table. Or consider mobile penetration... In 1997, 4% of the global population had access to mobile phones. By 2007, it was nearly 50%, and by the time 2020 arrives, it will have inched up to 75%.
Arbesman likes to call these facts Mesofacts.
Mesofacts are facts that are neither permanent nor subject to frequent changes. Their specialty is to stay under the radar and change themselves gradually. And it is this attribute that makes them dangerous. An inability to spot them could make your version of reality outdated without you even noticing.
With the newfound lens of mesofacts, I turned to look at the share market. And I saw that a large part of success in medium to long term investing comes from making sense of these mesofacts and updating one's version of reality when required. Using this lens could either help you find a fantastic investment opportunity, or give you the warning sign to get out of investments.
For instance, the appointment of a dynamic, new CEO, who's likely to shake things up is a positive change in mesofacts. It leads to a great investment opportunity. Or, the gradual erosion of the moat of a strong moat company is a negative change. A warning sign for making an exit.
Being aware of mesofacts and willing to change your stock's story will not eliminate all your stock picking mistakes. But it will certainly better your process and add meaningfully to your overall returns.
Do you have a story to share about how you were hurt or helped by the 'Mesofact Effect' on some of your favourite stocks? We are all ears...
Rahul Shah (Research Analyst)
Editor, Smart Contrarian
Editor's Note: Paying attention to the environment gradually changing around you is particularly important when investing for the long term, like say for your retirement.
To make sure you don't miss a trick, make sure you sign up for our service that does it for you. For stocks that you can invest in and then get on with your life, while we do the looking out for you, try StockSelect now.
Brain Food for the Day
Warren Buffett and Benjamin Graham's Defense Against Mesofacts
So, how did two of the greatest practitioners of value investing defend themselves against Mesofacts? We will let Buffett go first. Here's how he deals with it.
- Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago... a business that constantly encounters major change also encounters many chances for major error.
Smart, isn't it? Invest in companies that have products and services that will continue to exist at least a decade from now. This way, no need to analyze a lot of mesofacts and a low possibility of any of them falling through the cracks and hurting your returns.
Benjamin Graham is even more extreme. Here's what he said in an interview he gave in 1974 when asked whether conventional yardsticks like a company's projected earnings or market share is useful for evaluating stocks.
- Those factors are significant in theory, but they turn out to be of little practical use in deciding what price to pay for particular stocks or when to sell them. The only thing you can be sure of is that there are times when large numbers of stocks are priced too high and other times when they're priced too low. My investigations have convinced me you can predetermine these logical "buy" and "sell" levels for a widely diversified portfolio without getting involved in weighing the fundamental factors affecting the prospects of specific companies or industries.
Oops. Taking stock related mesofacts totally out of the equation. Only thing that matters for Graham is whether you are buying the stock cheap enough and whether you have a specific sell criterion. And mind you, this works. We have been using this trick since February 2014 to outperform the markets by a factor of nearly 3:1.
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