100 Ways to Beat the Market: #27: Look for disconfirming evidence.

At the USC Law Commencement Speech in 2007, Charlie Munger praised Charles Darwin as a model of rational, objective thought, particularly his habit of trying to consciously overcome first-conclusion bias. This is one of the many forms of over-confidence bias that can be damaging to your wealth.

Munger stated that Darwin, “tried to disconfirm his ideas as soon as he got’em. He quickly put down in his notebook anything that disconfirmed a much-loved idea. He especially sought out such things.”

Following Darwin and Munger, we too should seek out that which disconfirms our own investment theses. Put simply, you should try to kill our own ideas. It is far too easy to fall in love with a stock and then let your own rose-colored glasses glibly filter away anything negative about the business. Of course, this is delusional: the market does not care if you like a stock and reality will ultimately have its way.

This type of disconfirming thinking was on full display at the 4th Annual Pershing Square Challenge, in which Columbia Business School students compete for a $100,000 prize in an American-Idol like stock picking contest.

One of the finalist teams pitched Aeropostale (ARO). They argued that Aeropostale is a best-in-class retailer which earns consistently high returns on equity. They highlighted the company’s multi-year same-store sales growth, and growth opportunities coming from international expansion, e-commerce sales, and P.S. from Aeropostale, a new concept which targets pre-teens. Also, they liked Aeropostale’s valuation – the stock was then in the mid 20’s – because they thought it gave no credit for Aeropostale’s growth prospects and that the company’s unlevered balance sheet provided an attractive target to leveraged buyout firms.

The Aeropostale team received a respectful grilling from the judges, which comprised a cadre of value-oriented hedge fund heavyweights led by Bill Ackman. The hedge fund judges did not appear overly taken with the team’s thesis. The concerns the judges raised, which were summarized at the end of the presentation by Ackman, provides a text-book example of the types of things you should be looking for when you seek disconfirming evidence. Of course, it goes without saying that raising a concern is not tantamount to proving that it will come to pass, but the process of raising objections and dealing with them is critically important in reducing mistakes and generating market-beating performance. If you do this religiously, you will have a leg up on all your competitors and counter-parties who do not.

Returning to the Aeropostale pitch, here is Ackman’s summary of the disconfirming concerns.

1. Aeropostale does not do anything proprietary; in other words, they do not have a moat. They piggyback off the intellectual property of other teen retailers such as Abercrombie & Fitch.

2. Aeropostale’s thinner margins vis-à-vis its competitors makes it more vulnerable to higher commodity prices.

3. The growth opportunity is overstated. Aeropostale has already saturated the United States. In fact, Ackman questioned whether the total number of U.S. stores already exceeds the number of quality U.S. malls.

4. There is upward rent pressure and Aeropostale is susceptible to negative leverage if margins compress, given its fixed costs.

5. The market is used to strong same-store sales growth and could re-adjust Aeropostale’s multiple downward if the business generated negative numbers. [Note: the stock subsequently sold off to under $10 a share on poor same-store sales, among other factors, and has since rebounded to $16 per share.]

The lesson here is to look for disconfirming evidence, write it down (given the brain’s seemingly unlimited capacity to rationalize away this type of information), and take the time to give it serious thought before going forward.


4 thoughts on “100 Ways to Beat the Market: #27: Look for disconfirming evidence.

  1. Paul

    Greg, It should be noted that of Ackman’s criticisms of the ARO investment, the only one that is playing out is #5 (decline in same store sales leading changing investor sentiment and forcing the multiple down as current owners rush for the exits). Importantly, the lack of IP, cotton prices, rent pressures, etc. have not had a meaningful impact on ARO performance. That’s not to say that it won’t in the future, but so far it’s a combination of multiple seasons of bad inventory selling against other mall competitors discounting like crazy…a perfect storm of events that certainly make it a bad investment at $26 in April (when – based on events at the time – existing shareholders would have agreed with the Columbia business student assessment of the company’s strengths) but quite an excellent investment at $9 or even $16 if you believe it has a good shot at normalizing its performance within the next couple years and creating results on par with multi-year averages rather than the “peak” metrics it was showing coming out of FY 2010. Growth should hardly even matter.

    If the business school kids suffered from a specific mistake it was buying a retailer (no matter how good) when it was caught up in the euphoria of several years of improving comps and operating metrics (i.e., when existing investors are anticipating continued good news and probably can’t stomach bad news) vs. buying a quality retailer with an established niche after it has mis-stepped, disappointed shareholders, but has the balance sheet to survive and the ability to fix the problems.

    If they actually put their money into it, I hope they learned the lesson and added this to their mental checklists for future investments. You know the item…buy when there’s blood in the streets.

  2. Greg Speicher Post author

    Hi Paul, thank you for the comment. Rather than focus on the specific merits of ARO, I wanted to illustrate the type of thought process one should engage in when seeking disconfirming evidence, even if the potential concerns raised in the process can be overcome. If so, all the better because it increases the odds that you are not missing something. Having said that, I appreciate your perspective on ARO; you make a number of excellent points. I agree that it was an excellent investment at $9. I missed it at that price – classic sin of omission.

  3. Jago

    Another point of view on the same thing is: you should strive to have such a stock portfolio that given that you know pretty much all there is to know about any given company in your portfolio, you can still sleep very soundly no matter what the market does.

    Part of getting there is constantly looking at your holdings and trying to find any things you particularly dislike and when identified, figuring out if they are something you can live with.

    1. Greg Speicher Post author

      Jago, great point. Buffett gets at the same point when he say, “I want to be able to explain my mistakes. That means I only do things I completely understand.”


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