I first learned about this concept when reading Nassim Taleb’s book The Black Swan. He called confirmation bias “naive empiricism”. He said, “You take past instances that corroborate your theories and you treat them as evidence.” Further he writes, “I am saying that a series of corroborative facts is not necessarily evidence. Seeing white swans does not confirm the nonexistence of black swans.” He cites a study by P.C. Wason. In the experiment subjects were given a three number sequence of 2,4,6 and asked what rule would generate this sequence. “Their method of guessing was to produce other three-number sequences, to which the experimenter would respond “yes” or “no” depending on whether the new sequences were consistent with the rule. Once confident with their answers, the subjects would formulate the rule.” The problem is that most people will say something like 8,10,12. And the answer would be yes. After a couple of confirming examples you would announce that the rule was add 2 to the number before it, in succession. But the correct answer is actually any ascending numbers. I failed this example when I read it one of James Montier’s writings when he posed the question to the reader. I was reading about the problem and still fell for it.

How to prevent confirmation bias in our approach to investing?  Taleb directs us back to Karl Popper and his concept of “falsification.” We should attempt to prove false the ideas we are using. Again Taleb, “We can get closer to the truth by negative instances, not by verification!“  Popper, Taleb says leads the way out of our darkness, he “…introduced the mechanism of conjectures and refutations, which works as follows: you formulate a (bold) conjecture and you start looking for the observation that would prove you wrong. This is the alternative to our search for confirmatory instances. If you think the task is easy, you will be disappointed—few humans have a natural ability to do this.” In the Wason study, the way to figure out the proper rule would have been to submit numbers that declined, alternated, etc. To prove what the actual rule was by ruling out as many of the opposites as possible. It is only by figuring out what doesn’t work that you figure out what does.

The interesting idea to ponder is that if you are naturally a contrarian, like I am, you will be instinctively drawn to contrarian investing ideas, like value investing.  These ideas make more sense to me, than say momentum investing. But, am I really just looking for investing ideas that confirm my pre-existing biases? Perhaps.

It may also be why, even though I consider myself a value investor, I have not felt compelled to be bound by some rules that seem to appear in the blogsphere. Investing is ultimately a path, not a destination, this is just another pot hole to avoid.

Today as the market dropped over 2%, HAST dropped over 17% to exactly the price sold at last week. Regret comes and goes. I have moved on to other  investment prospects.

Also, remember that this profit in HAST is  only a 5.7% increase in the 80-20 portfolio. Now obviously if I could make 5% a month, every month I would be quite, pleased. But I don’t have those kind of expectations.

Disclosure: I have no current positions in HAST.

I do not recommend purchasing this stock anymore, since it has appreciated so much in the past two weeks. In fact it has come very close to my selling point. I did not get my order filled or I would have sold it today.

Here is why I purchased this stock

1. Piotroski F-score of 9 (out of a possible 9)

2. Net Current Asset Value of approximately $4.54/share (so, price was just under Net Current Asset Value.

3. Negative Asset Growth.

4. Altman Z score for non-Manufacturing companies 3.77

5. Price to Book .59

Strategy: Put in a limit order when it crosses 50% gain again, which it did earlier today, but my sell order did not get filled.

Disclosure: As of this posting I own 110 shares of HAST. I do not recommending buying them right now.

The first account I set up was the  Small Investor Portfolio. I started it with $2000. I will add $200/month to the account. It is meant to replicate what a beginning value investor or a value investor with a small amount of capital might be able to do on his own.  You can see the three stocks I have purchased for this portfolio already by looking at IFON, DUCK and ORXE.

This fund will be  primarily an asset valued portfolio relying heavily on Net Net stocks and other asset valuation strategies in the vein of Benjamin Graham. The stocks should have at least a 33% discount to Net Current Asset Value or some other Margin of Safety from intrinsic value.   I will create a spreadsheet to track the financial information that I glean from a companies financial statements. I will also read the latest 10k and 10Q’s looking for trouble or problems. Finally, I will do a little scuttlebutt research to see if I can see if there is a sig alert (for non Los Angelinos, that is when one or more lanes get shut down on a freeway) for the company. The Small Investor Portfolio will rely  heavily on analysis both quantitative and qualitative. I will take my cue mostly from asset valuation focused investors like Ben Graham and not from future earnings oriented investors like Warren Buffett. I will not be doing any Discounted Cash Flow analysis or looking for Owner’s Earnings growth. The strategy will be to identify these cigar butt, stocks that are discounted from their Intrinsic value and purchase them with a Margin of Safety. Unlike some other value investors I will include ADR (foreign stocks listed on an American exchange) and Penny stocks that trade on the Pink sheets or over the counter. The stocks should have a positive net income. The exceptions will be companies with positive operating income, with one time charges offs or discontinued operations. The other exception to positive Net Income will be biotech or pharma stocks with huge upside potential.  I will hold the stocks until I have reached the stocks intrinsic value or the circumstances surrounding the company change significantly enough to warrant a reevaluation of the company. If my estimation of the company’s value changes significantly in a negative manner, then I will sell the stock. In some cases I will utilize some special situation stocks in the manner outlined by Joel Greenblatt in his book You Can be a Stock Market Genius. I will explore these situations as they come up. And although ORXE was a NCAV stock, I consider it a special situation stock. With only $2000 to start, the small investor portfolio will be a Focused portfolio containing initially no more than 4 stocks. As the account grows with profits or the monthly capital additions I will expand this to at most 8 positions, and begin to increase the dollar amounts as the account grows. If the opportunity is there I will try to remain 80% invested at all times, retaining 20% in cash for new opportunities that come up, particularly if the market declines. If the Net Net and special situations dry up, I will stay in cash or reevaluate the investment strategy. This will be a long only portfolio. I will avoid financial stocks because I do not know how to evaluate their assets in a meaningful way.

The concept for the 80-20 investing portfolio is simple. Set up a few simple established value investing principles, make them stringent and then buy every stock that passes the criteria. So while the value investing criteria may be similar to the Small Investor Porfolio the strategy is not.  Some of these criteria  are concepts I have not yet covered in this blog, but I will post about them in the ensuing weeks. The criteria will include a combination of the following:

1. Price to Book ratio in the bottom 20% of stocks screened.

2. a Piotroski F score of 7 or better.

3. The annual growth in total assets should be in the lowest 20% of companies screened (currently negative double digit asset growth).

4. A passing score on the appropriate Altman Z score.That means above 3.o for Manufacturing companies and 2.6 for other companies.

5. Net Current Asset value equal to or greater than market cap.

6. Ratio of current P/E to 7-10 year P/E is less than 1.

7. Price to Sales ratio  less than 1.

There is no margin of safety per se. I think that by combing the different criteria that have been tested over the long term and then adding criteria that should minimize the down risk suck as Altman Z score, I am hoping that I have built in a margin of safety into the criteria itself.

In the future I will introduce a system for Hedging downside risk by using LEAPs or long term Asset Protected securities. This is the flip side to long positions. More about this in a future post. Thus this will be a long and short (although only using options) portfolio.

The strategy is buy as many of these positions as you can.  If I run out of cash, I will only replace a position in the portfolio with a better position. Since intrinsic value will be more difficult to calculate, I will hold the stock until the stock appreciates 50% and sell. If it declines or fails to meet my sell price I will sell at two years.

All the analysis has gone into the set-up. I will not be doing heavy analysis for this portfolio. In fact, apart from verifying that the company passes the criterias, I will do NO analysis. I will make sure that a company passes all the quantitative criteria and that is it. This will be a mechanical trading system in a similar to the magic formula investing strategy. Because I am expecting that more stocks will need to be purchased for this system to function, I have established the 80-20 Account with $5000. I will add $300/month to this account.

You might ask why I am not combining both criteria. It is simple. I am experimenting. There is some research that suggests that we are our own worst enemies in investing, that emotion, and poor decision processes will hinder our investment performance. I want to test these theories in a real and concrete way.  With 80-20 Investing I want to remove ego and emotion and see if it is possible to make money in a more simple way. Some of the Net Net companies don’t pass the risk thresholds I have set. But I am not sure that means that they are statistically worse investments. I am attempting to discover for myself what really works.

This will be a true experiment in the sense that I cannot forecast the outcome. There seems to be contradictory research out there that suggests that value investing is superior to growth investing, but also that human’s are certain psychological limitations that may limit us from truly maximizing returns, even if we know we are engaging in the limiting behavior. Thus the 80-20 investing Portfolio is an attempt to remove as many of my own limitations from the process as possible.

The biggest hurdle to this kind of investing is devising the system with which to follow. I have almost finished the development stage for  the criteria I will use for buy and sell signals. They will of course be value oriented and research driven. I will lay the criteria out in a separate post, that should be lengthy so I can refer to the research supporting the theory of investment criteria. If you have any thoughts on this subject I would love to hear them.

The important distinction between Value Investing and speculating is that Value Investing involves research, and some analysis. Mostly, it is about properly valuing a company and buying at a discount to intrinsic value. Speculating requires you guess the correct direction of a market, stock or commodity. Within that statement I am not sure that this concept actually falls within the simple concept of value investing I just laid out. The paper is called The Asset Growth Effect in Stock Returns by Cooper, Gulen, and Schill. You should read it. It is not hard to follow. And they do a better job than I do of explaining their own findings. However for the 80/20 people…

Here is the concept: take all non financial, US stocks and look at their growth in assets, Total Assets( t)- Total Assets( t1)/ Total Assets (t1). Then you arrange then in deciles (10% groups) from highest to lowest. The lowest deciles of Asset growth stocks beat the highest decile by more than 20%/year. This equals a return of 23.28%. Not too shabby. But this is another typical value investing idea that is sort of like Einstein’s theory of relativity. The more you explore the more it defies the world that you know. This research seems to imply that hi ROA companies are likely to experience sub par returns while low ROA companies will likely have outsized returns. Isn’t that contrary to everything we learn in Investing 101? But if you look at Table 1 of the study, the high asset growth companies have an average ROA of 21%. Sounds great, right? The low asset growth rate stocks averaged -3.1% ROA.

There are actually a couple of problems for the practical investor. First, the strategy seems to require a relatively large outlay of stock purchases, which is simply not feasible for the small time investor. If you are required to buy 10% of the stocks evaluated that is hundreds and hundreds of stocks. Second, the What is wrong with Back Testing phenomenon is also important to take note of here. Any back tested concept that requires a specific purchase date and rebalancing time frame, has the potential to buy and ineffective or unprofitable times, when a less inflexible model might not. But who knows. I am still reeling from the concept that low ROA may be good.

For followers of this site you will understand why this is doubly interesting to me.

First, it follows a value based approach to investing.

Second, it fits into the 80/20 style of investing.

Before I get to the interesting results, here are the 10 criteria

1. An earnings-to-price yield at least twice the AAA bond yield.
2. A price-earnings ratio less than 40 percent of the highest price-earnings ratio the stock had over the past five years.
3. A dividend yield of at least two-thirds the AAA bond yield.
4. Stock price below two-thirds of tangible book value per share.
5. Stock price two-thirds “net current asset value.”
6. Total debt less than book value.
7. Current ratio greater than two.
8. Total debt less than twice “net current asset value.”
9. Earnings growth of prior ten years at least 7 percent on an annual basis.
10. Stability of growth of earnings in that no more than two declines of 5 percent or more in the prior 10 years.

According to the Gurufocus article The Investment Methods of Benjamin Graham. The first five criteria were related to reward and the second five to mitigating risk of loss of capital. One needs to select a stock with at least one from the reward and one from the risk mitigation section. Very few if any stocks will pass all 10 critieria.

Oppenheimer discovered that two of  the criteria, number 1 and number 6, produced exceptional returns.

Oppenheimer found that the mean return during the time studied (1974-1981) was 38% vs. the S & P 500’s 14%. A remarkable out-performance.  He also found that using criteria 3 and 6 would have achieved mean annual return of  26%.

How do you use this criteria? Old Ben said to hold the stock for two years or 50% appreciation, whichever came first.

I wonder if this study has been updated or researched for a longer period of time. If it is still true, why would anyone try anything else. This may be the highest substantiated automatic formula I have ever heard of, and yet it gets strangely little coverage from Tweedy Browne.

I know we think that more information is better, but it isn’t.  Just read the writings of Malcolm Gladwell to grasp this concept. Here is where the heresy comes into play. That is also true in the investing world. In fact, sometimes more information produces a worse result because we have too much confidence in our decisions, and that over confidence dulls are decision making process. I have been thinking of how specifically 80-20 Investing would work for investing. Perhaps you will have some ideas and would like to add to the conversation. 80-20 Investing will not be an  approach for everyone. It is not the lazy man’s way to riches.  But, it may be ideal for Beginning Investors, small time investors, part time or weekend investors, in short, anyone who doesn’t want to abdicate responsible for their investments, but either doesn’t have the time or the inclination to spend their life (80% at least) making investment decisions.

I have listed a few ideas that are the genesis of 80-20 Investing. This list will be refined, added to, tweaked and finalized in the coming months, and ultimately, I will  set up an 80-20 portfolio distinct from the Chroma Investing portfolio. Since I am putting my own money down, all I am really interested in, is what works.

1. KISS. Keep it Simple Stupid. Yup, I am not above using bumper sticker slogans when it suits the idea.  I am not as smart as Warren Buffett, so 80-20 needs to be simple. This is the gospel. It doesn’t get much easier that buying a Net Net stock at a discount and selling it when it gets to full value.

2. Use Simple proven models. Like Altman Z-score. Dump any model that you cannot easily set up in Excel. I am not kidding. If I can’t understand it, it won’t help me. If there is no evidence for the model, either set up a test real money portfolio to track its performance or dump the model.

3. If an investing approach stops working, switch investing approaches. It is likely when the market gets frothy at some point in the future there won’t be my main stay of investing, NCAV stocks, when that happens I will already have other investment prospects working.

4. If something can be done automatically, do it automatically, If it must be done manually ,do it manually. Investment screens can be set up automatically, and with the right software, alerts can be added, etc.. But the important details, that were set up automtically, must be checked manually.

5. Make sure you cover your ass. Er, backside. The most important thing is preservation of capital. If you are going to take risks with your capital, make sure you understand them, and you are minimizing them. Think Nassim Taleb and the ideas contained in Fooled by Randomness. I read on another blog where someone could not distinguish the risk difference between shorting a stock and buying put options on that stock. Their are risks in both scenarios. A put option has only the risk of the premium paid for the put option. You know the total risk, that is potential loss of capital, from the moment you buy the put option. When you are shorting a stock you have two risks, the theorectial unlimited risk of a stock rising against you. This can be mitigated with smart stop loss triggers. But you cannot control margin calls on short positions, which as we saw in the financial collapse of ’08 forced some investors in to forced sale positions.

I think that is enough for the first edition of 80-20 investing. Please, if you have ideas contribute at chroma@chromainvesting.com or by posting a comment. If you like this blog please use the “share” feature that is at the end of every blog to share Chroma Investing with people on Digg, Facebook, to email etc.