WWII 037: Using the Scientific Method in Investing, Betting with a Portfolio of IPOs, Donald Trump Mentioned in Earnings Calls
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This episode is all about how I use one aspect of the scientific method in my investment process, and how you can use it in yours to make your process more efficient and find the good ideas faster.
Main Topic: Forming a Null Hypothesis and Attempting to Prove It
In order to be as efficient as possible in my investment process, I have incorporated some aspects of the scientific method that I learned many years ago while taking an experimental psychology course in college.
Investment ideas can be easily grouped into two piles: bad ideas, and ideas for further research. To save time, I created several gates that an idea would have to pass through to be considered for further research. The gates are simple and obvious and are non-starters. If an idea doesn’t pass through a gate, it gets put into the “bad idea” pile and all work on it stops.
In the scientific method, as pertains to experiments, you form a null hypothesis (the opposite of what you are trying to prove). In my case, my null hypothesis is that it’s a bad investment idea. If I prove that null hypothesis, I set that idea aside and move on to the next one.
If you fail to prove the null hypothesis, then you can reject the null hypothesis and you may have proved your actual hypothesis. In my process, I continually try to prove that it’s a bad investment candidate (prove the null hypothesis). If I can’t prove that it’s a bad idea, then I may have found a good one and I put it on the “further research” pile.
By focusing only on ideas that pass through the first few gates, I maximize my time spent on potentially good ideas, and minimize my time spent on bad ideas. Let’s be clear, there are more than 10,000 public companies on the U.S. stock exchanges, and time is an investor’s most precious resource. Anything that you can do to focus only on good ideas is a good thing.
This method of attempting to prove the null hypothesis becomes even more powerful as the idea continues through more gates. As I continue with my research on an idea, I keep attempting to prove that it’s a bad investment. This null hypothesis method short-circuits a typical trap that investors fall into when they spend a lot of time on an idea. Even if they find things they don’t like about it, they end up wanting to invest in it just because they spent so much time researching it. The idea of having wasted time is more painful than the potential investment losses. Weird…right? But it’s just one of many heuristics that cause us to make poor investing choices.
This is experience talking, by the way. Every type of mistake I write about, I have made myself. My hope is learn from them and to never make the same mistake twice.
To make things even more clear, here are some of the gates I am talking about.
On initial review – here are some of the “non-starter” gates (keep in mind I apply these differently to different industries and different business models);
· No earnings for years
· No free cash flow for years
· No revenue growth for years
· Not enough history
· No operations (holding companies looking for acquisitions)
· Earnings that haven’t grown over a decade
· Revenues that haven’t grown over a decade
· Earnings fluctuate between positive and negative
These are not all the gates I use, but are some obvious examples. If a candidate has any of the above attributes, I have proved the null hypothesis and I put it in the “bad idea” pile and move on.
Because I want to expose myself to as many public companies as possible, I don’t simply use screens to narrow down a search as screens often screen out candidates that may have something else going for them that would make them attractive, like hidden assets, or temporary problems affecting earnings, etc.
Thoughts on this? Leave a comment!