First Rate Fundamental Analysis
plumbing leaky abstractions & contradictory expectations
[Note: this is a re-write of a piece which was originally written in 2005.]
“All non-trivial abstractions, to some degree, are leaky. Abstractions fail. Sometimes a little, sometimes a lot. There's leakage. Things go wrong. It happens all over the place when you have abstractions.”
Joel Spolsky, The Law of Leaky Abstractions
“The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.”
F. Scott Fitzgerald, The crack up.
First rate fundamental analysis is about finding two or more opposing facts, and discovering how it is that both are true. It is not just functioning while holding two opposing ideas in the mind at the same time but actually being energized and motivated by the paradox.
The paradoxes that the fundamental analyst seeks are often a result of leaky abstractions. When we abstract, we inevitably simplify, loosing something of the description of a specific item to extend the description to a larger set of items. Computer programming relies on abstraction, just as accounting does. All languages – whether in the context of business transactions or bits and bytes, are based on systems of abstraction. Thus they all leak.
But you probably don’t think – wow – what was leaky about that last sentence I uttered, or that last transaction I made. But in some fashion a good analyst is thinking about precisely what information the price mechanism, or other language, has missed.
SO WHERE DOES THE ANALYST BEGIN?
With a hypothesis of how to measure two contradictory forces, which are translated into a search of either qualitative or quantitative sources.
For example, one might begin with simple quantitative screens, looking for two opposing ideas present in the data associated with one company, such as companies with rising dividend payments and decreasing or flat stock prices. Find me companies with lower expectations in the stock price than they have had in the past, but which still have several signs of financial statement strength. The conflicting is between the expectations in the current price versus the company’s historical or expected financial performance, or actions the company is taking to invest in it’s business.
OPEN SECRETS
Normally, the gap in expectations is between the market expectations and the company management’s expectations. Understanding this gaps is not about seeing something no else sees. The market expectations are in the current stock price, or more broadly current prices. Management expectations are embedded in their capital allocation decisions, which are shown in the financial statements and discussed in corporate communications. This gap between the market perspective and management plans is always an open secret.
The best company research focuses on companies and management teams whose plans the market is skeptical of, and coming to our own independent assessment.
AN EXERCISE IN INSANITY OR HUMILITY
Qualitatively, first rate fundamental analysis involves taking something that seems insane to us and asking how it makes sense? In other words, while not accepting that a price or investment would make sense for us - a first rate analyst is able to look at every price and investment and understand who it makes sense for and why it makes sense to them. We assume that no one is stupid or insane, but that different investors have different incentives and perspectives and everyone is just making the best decisions for themselves. It may just seem insane because investor preferences and incentives are not monolithic and different investors inevitably contradict each other. Contradictions are what makes a market - the contradictions are why you can have buyers and sellers at the same time, no?
The recent period of neagtive interest rates is a good example of where we would apply this sort of analysis. Because for us the idea of buying a bond with a guaranteed negative return if held to maturity seems insane, but for some reason it made sense from an overall portfolio perspective for trillions of dollars of investment capital - for a while.
CLOSING
We are price takers. That’s the structure of the market. We don’t control the prices that get flashed at us. We do control whether we take the price. This is another of those paradoxes. You don’t control the price, but nothing matters more than controlling yourself in the face of prices -- price taking discipline.
So first-rate fundamental analysis is about dealing with and reconciling contradictions that begin and end with prices. Finding the leaks in the price mechanism.
In the case of companies, this boils down to the difference between market expectations discounted in the stock price compared to management expectations revealed by how the company is allocating its capital. The first rate analyst then does the work to understand the contradictory market expectations and management expectations and takes a side.