We tend to overcomplicate things in the world of investing. By constantly trying to find hidden gems and mispriced stocks, it’s too easy to miss really good businesses sitting right there in front of you. Sometimes, the obvious answer is the right answer, particularly if it doesn’t require heroic assumptions or a series of miracles for it to work out favourably.
I’ve started applying the principle of Occam’s Razor more regularly in my life and my portfolio. At its core, this is a probability-based theory that the most obvious and simple answer is usually the right one. Instead of focusing on the outliers and the less likely events, thereby becoming paralysed by fear along the way, taking this approach means making logical decisions grounded in common sense.
A couple of years ago, I prepared a discounted cash flow valuation of Shoprite. It was absolutely clear that Shoprite was doing extremely well and winning market share, but what if the others caught up? What if the valuation was simply too high relative to growth prospects? Would the market keep paying up for a defensive stock, or would the multiple unwind over time and lead to a lower exit multiple? What about load-shedding?
A whole lot of ‘what ifs’ later, instead of buying Shoprite and making great returns I had convinced myself that it was too obvious
A whole lot of “what ifs” later, instead of buying Shoprite and making great returns I had convinced myself that it was too obvious. After all, don’t you have to be contrarian to make money? I missed out on irritatingly obvious upside through an abundance of scepticism and a stubborn desire to do something different to the herd.
To make things worse, I looked at Spar at one point and thought that the market might be missing a trick, with good news surely just around the corner to improve a depressed share price. I eventually gave up on that trade and lost money on it, though I’ve subsequently made it back in more recent Spar trades. Had I just bought Shoprite instead, I wouldn’t have needed to make anything back — I would simply have watched the share price work its magic for me.
If I had interviewed 100 people at the time and asked them which retailer was a better business, I can just about guarantee that Shoprite would’ve won by a landslide. My mistake was assuming that the valuation of Shoprite had been driven too high by the positive light in which the business was viewed. I managed to overthink it, irritate myself with a complicated discounted cash flow analysis and ultimately lose out.
The solution? Occam’s Razor and common sense. My approach these days is to force myself to think about why the obvious answer isn’t the right one. Unless I can come up with excellent arguments to shift my base case along the probability distribution of outcomes, I accept that a good business will probably be a good investment and a bad business will probably lose me money.
I have great respect for those who dig through the dustbin in the hope of finding treasure and manage to get it right. Not only is this highly skilled work that requires a deep understanding of financial statements, but it ends in tears far too often as the companies in the dustbin have no resilience to anything going wrong. To go from black drawstring bag to multi-bagger requires a lot of things to go right. Even when they do, chances are good that portfolio sizing means that a basket of broken stocks still doesn’t work out well as the one winner is too small. The temptation to take highly concentrated positions to avoid this is a problem, as desperation to pull the trigger on an idea can cause you to convince yourself of crazy things about the risks involved and the potential upside.
My newfound respect for Occam’s Razor is why I’ve successfully ridden the entire WeBuyCars share price wave since the company was separately listed, avoiding the temptation to trim my position despite a gain of 70% in a matter of months.
Has the share price run too hard? With a short-term lens, probably. Is this still a strong business with excellent growth prospects and one of the better positions in the automotive industry? In my view, that’s a strong yes. I therefore cannot convince myself that the valuation is more of an issue than the operational bull case, so I haven’t sold and don’t intend to sell. Don’t let me down, William of Ockham.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.