When I invest in companies, I don’t vouch for or give a character certificate to management. I look at the past and current behavior and then try to arrive at a judgement. In majority of the cases, past behavior is a good indicator, but we do get surprises from time to time.
If new
developments make me change my view, I will not try to defend my past decision
which was made on a different set of facts. The key is to rationality is to
evaluate new facts appropriately and move on from there. As John Maynard Keynes
said a long time ago – when facts change, I change my mind. What do you do sir?
Let’s move to
the point of how to evaluate management quality in light of poor behavior? For
starter, there is no formulae which will give the answer. The best analogy to
judge management quality comes from the court system in passing verdict on
defendants. A defendant is assumed innocent till proven guilty.
I personally try
to look at management with a neutral view when I start analyzing a company.
They are neither good nor bad. This is a very important point. I have seen majority
of investors start with a presumption of a good or bad management and then
collect evidence to prove it. It is very easy to make an assumption and gather
enough evidence to prove your point.
The fallacy of obviousness
See this wonderful
article which makes the same point. I would highly recommend reading this
article. Some excerpts -
So, given the problem of too much
evidence – again, think of all the things that are evident in the gorilla clip
– humans try to hone in on what might be relevant for answering particular
questions. We attend to what might be meaningful and useful
However, computers and algorithms –
even the most sophisticated ones – cannot address the fallacy of obviousness.
Put differently, they can never know what might be relevant. Some of the early
proponents of AI recognised this limitation (for example, the computer
scientists John McCarthy and Patrick Hayes in their 1969 paper, which discusses
‘representation’ and the frame problem).
In short, as Albert Einstein put it
in 1926: ‘Whether you can observe a thing or not depends on the theory which
you use. It is the theory which decides what can be observed.’ The same applies
whether we are talking about chest-thumping gorillas or efforts to probe the
very nature of reality
Equal
priors
The key is to
start without an assumption (50-50 probability for both scenarios or equal
priors) and look at the meaningful (and not trivial) evidence to come to a
conclusion. Once you have done that, your conclusion should not be set in
stone, but treated as a hypothesis which can change based on new evidence.
If the
management continues to behave well, your confidence is increased. If you start
seeing negative behavior, your confidence goes down and at some point (which
cannot be mathematically defined), you may lose faith in the management and
exit the position.
The above approach is fancifully also
called Bayesian
reasoning.
One should think
probabilistically when evaluating management and not consider these issues as
black or white. That’s the essence of Bayesian reasoning.
The central
point of this approach is to look at new evidence in light of your prior
conclusion and change it in proportion to the evidence. In some case, the new
episode may be a small one and will cause you to reduce your level of
confidence a bit. In other cases, either the episode or series of episodes will
be so awful, that you will be forced to change your mind completely.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.
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