Value Investing

Michael Mauboussin: How Well Do You Compare?

Years ago, Dan Ariely, a professor of psychology and behavioral economics at Duke University, was surfing the Web when he found an advertisement for an annual subscription to the Economist, a weekly magazine that covers politics, business, and other news. Similar to most magazines, the Economist offers both an online and a print subscription.1

H/T Tren Griffin

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The prices struck Ariely as odd. They appeared one after the other. He first saw the online version, which was $59. Seemed reasonable. Next was the print version at $125. A little pricey, but still sensible. Finally, the price for both the print and online version was also $125. He did a double take. Why buy the print version only when you can get the print and online version together for the same price?

Comparing is something we humans do quite naturally, but you and I are not always good at it. If you are a perfectly rational person, you gather all of the salient information about your alternatives and select the option that maximizes your utility. This is a fancy way of saying you pick what makes you happy. You might favor either the online or the print version of the Economist, but it is clear that if you prefer print you should choose the offer with the free digital version.

Ariely suspected there was more to the story. So he did some experiments with his students in business school. The first group of subjects saw all three offers. Sixteen percent chose the online offering, 84 percent the print and online version, and none selected print only.

For the second group of subjects, Ariely dropped the option to select the print-only version. That no one in the first group selected that option underscored the obvious point that it was an unattractive choice even for those students who preferred print. With the option omitted, you would still expect the preference for digital versus print in the second group to be similar to that of the first group.

But that is not what Ariely saw when he tallied the choices of the second group. Now, 68 percent of the students went with the online version and only 32 percent with the print version (see exhibit 1). In effect, the unattractive option was a decoy that swayed the choices in the first group and boosted the Economist’s hypothetical sales by more than 40 percent.

Those sharp business school students did not compare as economic theory dictates they should have. How Ariely presented the options shaped their ultimate choices. We are not optimized for choosing. The way alternatives appear and how we think shape our decisions.

Dan Gilbert, a professor of psychology at Harvard University, summarizes the situation well: “The facts are these: (a) value is determined by the comparison of one thing with another; (b) there is more than one kind of comparison we can make in any given instance; and (c) we may value something more highly when we make one kind of comparison than when we make a different kind of comparison.”2

Michael Mauboussin

The ability to compare effectively is a vital skill in investing. Exhibit 2 shows the types of choices an investor, or investment manager, faces. Comparing well requires understanding the objective, considering the correct alternatives in fair fashion, and avoiding many common mistakes in assessment.

This report is about how investors compare. We start with a discussion of how people compare in general, with an emphasis on when we compare effectively and when we tend to make mistakes. We specifically consider the comparable company analysis that investors use as part of their valuation work. The multiples of earnings and cash flow of the peer group that an investor selects can make the focal company appear relatively cheap or expensive.

Next, we turn to methods to improve the process of comparison. Here we share some tools to manage or mitigate some of the mistakes that we might make if we are not sufficiently careful.

Finally, we discuss a means to construct a comparable company analysis. An investor can use this approach to select securities and hedge.

Michael Mauboussin

Methods We Use To Compare and Their Limitations

Analogy. Cognitive scientists have spent a great deal of time studying how we compare.3 The primary mechanism we use is analogy. Analogy is an “inference that if two or more things agree with one another in some respects they will probably agree in others.”4 Douglas Hofstadter, a renowned professor of computer and cognitive science, has suggested that analogy is “the core of cognition.”

The application of analogical thinking generally has four steps.5 First, we select a source analog that we will use as the basis of comparison with the target. Usually, the source comes from our memory. Second, we map the source to the target to generate inferences. Here, we are often looking for similarities. Third, we assess and modify these inferences to reflect the differences between the source and the target. Finally, we learn from the success or failure of the analogy.

For example, Andy Grove, then chief executive officer of Intel, heard about how mini-mills had disrupted the integrated mills in the steel industry.6 He saw similar dynamics in the microprocessor industry, with Intel as the equivalent of the integrated mills. This encouraged him to lead the effort to launch a low-end microprocessor, called Celeron, to avoid a plight similar to that of the integrated mills. Grove drew an analogy that successfully shaped Intel’s strategy.

Analogy can be a powerful way to compare, but there are common mistakes in its application. Here are a few based on the first three steps:

Step 1 mistakes: Most people rely on their memories to retrieve analogies.7 Psychologists call this the availability bias, and it shrinks the scope of inquiry. Because our experiences and memories are limited, we fail to identify proper analogies.8 This is a recurring source of failed decisions. For example, you can imagine a company’s chief executive officer (CEO) comparing a current acquisition, by analogy, to a past acquisition that was successful. The CEO fails to consider a larger sample of deals that likely provide a richer analogy because the prior success is what comes to mind.

So the first failure is not finding an appropriate analogy because of a lack of breadth. Limited or biased recall and search is the source of this shortcoming.

Step 2 mistakes: The second failure is a lack of depth. This is a faulty inference based on the superficial features of the analogy. Another way to say this is the analogy suggests correlation but fails to identify causality. Solid theory is rooted in causality. The process of theory building raises the level of understanding from one based on attributes to one based on circumstances.9

Clayton Christensen, a professor of management at Harvard Business School, introduces this idea through man’s quest to fly. The obvious analogy is birds or, more accurately, animals with wings and feathers. Not all animals with wings and feathers can fly, and not all animals that fly have wings and feathers. But as Christensen likes to point out, the correlations are high.

The intrepid humans who sought to fly pursued a logical strategy. They fashioned wings covered with feathers, attached them to their arms, went to a high spot, jumped, and flapped. Then they crashed. The attributes of wings and feathers are not enough for flight. Much later, scientists learned how lift, and hence flight, works. The circumstances of flight allow us to fly 350-ton aircraft around the world.

Speaking of large aircraft, Boeing provides a case for this mistake in the world of business.10 Many companies, including Apple, Cisco, and Dell, have enjoyed the financial benefits of outsourcing. A company that outsources hires external suppliers to provide goods or services the company used to deliver internally. For instance, Apple outsources some assembly of its iPhones to Foxconn. This allows Apple greater focus, more profits, and less capital intensity. These are generally good things in the world of business.

 

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