theory driven investing

7/30/2019 Theory Driven Investing

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The Theory-driven Stock Investor

By Ronnie Ng (www.facebook.com/bolametrics)

The Theory-driven Stock Investoris an amalgamation of ideas & theories from Warren Buffett & Clayton Christensen.

The phrase past performance is not an indicator of future results, or some variation of

it, can be found in the fine print of investment product literature. Yet due to either force

of habit or conviction, investors and advisors alike consider past performance to be the

most important factor in stock selection.

Most investors are people driven by past financial data, and use it to predict the future

share price of a business. As number crunching analysts, some of them might argue that

using theory to estimate a companys worth is impractical, since it is normally associated

with the word theoretical. However, a good theory is practical because a well-

researched theory is a contingent statement of what causes something and why. The law

of gravity, for example, actually is a theory. It is extremely useful because it allows us to

predict in advance, without having to collect historical data, that if we step off a cliff, we

will fall. Good theories allow us to predict the result of an action accurately.

Even though most investors do not think of themselves as being theory-driven, they are

in reality voracious consumers of theory. When an investor chooses to buy, sell or hold

his shares, it is based on some theory or mental model in the back of his mind that leads

him to believe that his decision will lead to the desired financial result. The problem is

that investors are rarely aware of the theories they are using and often use the wrong

theories for their investments. It is the absence of conscious, trustworthy theories of

cause and effect that makes success in stock investing seem random.

Most stock analysts and advisors are careful not to make assertions that are not backed

by past data of a companys stock price. The problem with this approach is that data is

only available about the past, and the only convincing data available pertains to the

recent past. There is no data for the future, so we have to ask ourselves how we can

predict the future.

A popular method involves analysts measuring the price fluctuations of a stock against

the price fluctuations of the market. This approach represents correlation rather than

causality, and it does not help predict the future. For example, the Beta () of a stock is

a number describing its volatility in correlation to the volatility of the benchmark that

stock is being compared to. Seth Klarman, the author of the book Margin of Safety,

says it brilliantly:

"I find it preposterous that a single number reflecting past price fluctuations could be

thought to completely describe the risk in a security. Beta views risk solely from the

perspective of market prices, failing to take into consideration specific business

fundamentals or economic developments. The price level is also ignored, as if IBM selling

at 50 dollars per share would not be a lower-risk investment than the same IBM at 100

dollars per share. Beta also assumes that the upside potential and downside risk of any

investment are essentially equal, being simply a function of that investment's volatility

compared with that of the market as a whole. This too is inconsistent with the world as

we know it. The reality is that past security price volatility does not reliably predict future

investment performance (or even future volatility) and therefore is a poor measure of

risk."


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Seth Klarman is right to suggest that correlation is never perfect because there are

always exceptions. You can use correlation to generalize to a population but not to

individuals. For example, even though students in small schools have been observed to

have higher scores on standardized tests, not all students' scores would go up if we

made schools smaller. There is a correlation between small schools and higher scores,but there is no causality. If we can harness an understanding of causality through the

formulation of valid theories, we can better estimate the intrinsic worth of a company.

First, Id like to introduce you to Clayton Christensens JTBD Theory.

The Jobs-To-Be-Done (JTBD) Theory

When customers find that they need to get a job done, they hire products or services

to do the job. Hence, in order to measure the intrinsic value of a business, we need an

understanding that mirrors how the companys customers use its product or service to

get a job done. Jobs-to-be-done (JTBD) are what cause people to bring a companysproduct or service into their lives. Customers buy things because they're trying to get a

job done, and we can't understand the companys intrinsic value unless we understand

the job those customers are trying to get done. Every customer has many jobs to get

done each day from staying awake during a car ride to feeling successful at the end of

each day. The stock markets volatility cannot explain why a man takes a date to a

movie on one night but orders in pizza to watch a DVD at home the next.

Warren Buffett, the worlds greatest investor, probably saw the world this way. Buffett

understand the jobs that arise in customers lives for which their products might be hired.

Through his investment vehicle, Berkshire Hathaway, Warren Buffett owns the shares of

Coca-Cola, Sees Candies, and Gillette. Buffett has famously said these words:

Cola has no taste memory. You can drink one of these [Coca Colas] at 9:00, 11:00,

3:00 in the afternoon, 5:00. The one at 5:00 will taste just as good to you as the one

you drank earlier in the morning. You cant do that with cream soda, root beer, orange,

grape, you name it. All of those things accumulate on you. Most foods do. And

beverages. You get sick of them after a while There is no taste memory to Cola. And

that means that you get people around the world that are heavy users, that will drink

five a day Theyll never do that with other products. So you get this incredible per

capita consumption.

"When you were a 16-year-old, you took a box of candy on your first date with a girl and

gave it either to her parents or to her. In California the girls slap you when you bring

Russell Stover, and kiss you when you bring See's."

When I go to bed at night I figure that by the time I wake up 200 million Cokes will

have been consumed. Weve got some Gillette [shares] too, and every night I think

about two billion plus mens hair growing and four billion womens legs with hair. It goes

all night when I sleep.

So, how can an investor figure out the customersJTBD by the product or service of a

company whose stocks he intends to purchase? The jobs that customers are trying to

get done cannot be deciphered from monitoring the daily fluctuations of the company s

stock prices. The investor is required to observe, consume, write and think. It entails

knowing where to look, what to look for, how to look for it and how to interpret the JTBD.


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A large marketing expenditure is a symptom of a company that doesn't understand the

job(s) of its product very well. If a product does the job well, people will pull it into their

lives naturally such that marketing won't even be necessary. Some other companies that

seem to understand this concept of jobs quite well include IKEA, SAS, and Zara. These

companies' products themselves might be easy enough to copy, but no one has been

able to get the job done in the same way that these companies have.

There are three dimensions inherent in every job: functional, social, and emotional. Once

a company understands those dimensions of the job, then it becomes important to

consider theintegrated experiencesthe company must provide to enable the customer

to do the job perfectly.

Integrating the customers experience correctly to get the job done means:

(1) Whereas products are easy to copy, integration around a JTBD widens the companys

economic moats.

(2) Customers are happy to pay a profitable price instead of having a zero-sum

relationship.

When a companys product does a job well, it unlocks a purpose brandvalue, which is

not reflected in its stock price. A purpose brand links customers realization that they

need to do a job with a product that was designed to do it. During the early years after a

products launch, when volumes are small, word-of-mouth advertising is far more cost

effective than media advertising. Positive word-of-mouth advertising only can be

achieved after customers have used a product that did the job well. A very long list of

powerful brands, including FedEx, Starbucks, and Google were built just this way with

minimal advertising at the outset. These brands pop into customers minds when they

need to do the jobs that these products and services were optimized to do.

A clear purpose brand acts as a two-sided compass. On one side, it guides customers to

the right products. The other side guides the companys product designers, marketers

and advertisers, giving them a sense of true north as they develop and market new

and improved versions of their products. A good purpose brand clarifies which features

and functions are relevant to the job and which improvements will prove irrelevant.

The brand value in excess to its current stock price is the wage that customers are

willing to pay the brand for providing this guidance on both sides of the compass. Thus,

when an investor understands who the company is up against in the mind of the

customer, he can piece together the real size of the market in which it competes. Withthat, the investor will be able to estimate more accurately, the intrinsic worth of the

company.

Quite possibly, the root reason of a bad investment is not that the business s future is

intrinsically unpredictable. Rather, the problem could lie in some of the fundamental

paradigms that he follows in understanding how the companys products help its

customers get their jobs done.

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