The Magical Rule of Four, or Maybe Seven

Here is your weekly Saturday newsletter, where I share the latest updates from the site, a new idea worth thinking about, few stories you shouldn’t miss, a question from my mailbox, and a question for you. Let’s get started.

On SN This Week

• A Simple Formula for Survival in Life and Investing
• Why I Write What I Write?
• Chance Has No Memory

A New Idea: The Magical Rule of Four, or Maybe Seven
How do you remember phone numbers? In groups of 3, 4, or 5?

For example, if my friend’s phone number is 1234567890, I would remember that as 12345 – 67890. Some people remember as 123-456-7890. And some as 1234 – 5678 – 90. But I rarely find people remembering numbers all at one go, as in 1234567890. And why does this happen? That most of the times we cannot remember such large numbers at one go, and would rather break them into chunks?

The reasoning is that our brain may only be able to hold three or four things in our conscious mind at one time. Researchers have often debated the maximum amount of items we can store in our conscious mind, in what’s called our working memory. A new study puts the limit at three or four. Beyond that is what we call information overload.

Of course, the memory capacity of the human brain is extremely large and we don’t have to worry about running out of space in our lifetime. Scientists claim the brain’s memory storage capacity to something closer to around 2.5 petabytes (or a million gigabytes). If you wish to imagine that, imagine if your brain worked like a digital video recorder in a television, you would have to leave the TV running continuously for more than 300 years to use up all that storage. That’s extremely large, right?

But what I am talking about is not the brain’s memory storage, but its working memory.

Also known as short-term memory, the working memory holds information that is relevant to performance and ensures task focus. It’s what allows us to remember and retrieve information from an early step of a long task, such as long-division math, or analyzing a company’s annual report.

Working memory storage capacity is important because cognitive tasks can be completed only with sufficient ability to hold information as it is processed. And researchers suggest we tend to become more confident and less accurate as we process increasing amounts of information, often when that amount is greater than three or four.

Now, a humorous paper titled “The Magical Number Seven, Plus or Minus Two” suggests that the number of objects an average human can hold in short-term memory is 7 ± 2.

So, we are still not sure whether that magical number of the amount of information our working memory can process well is four or seven. But we are sure of one thing. And that is that we can handle only small amounts of information at once.

And so, when it comes to analyzing which stocks to pick up and which ones to avoid for investment, it is wise to employ no more than four or maximum seven criteria.

For example, this may include asking just these seven questions –

1. Is the business simple to understand and run? (Complex businesses often face complexities difficult for its managers to get over)
2. Has the company grown its sales and earnings consistently over the past 5-10 years? (Consistency is more important than speed of growth)
3. Will the company be around and profitably better in 10 years? (Suggests a long runway of growth and continuity in demand for the company’s products/services)
4. Does the company have a sustainable competitive advantage? (Pricing power, gross margins, lead over competitors, entry barriers for new players)
5. Does the company require consistent capex and/or working capital expenditure to grow its business? (Companies that have to spend continuously on such areas, especially capex, are like running on treadmills, which is not a good situation to have)
6. How good is the management given the hand it has been dealt? (Capital allocation, return on equity, cash generation, debt-paying capacity, corporate governance, performance against competition)
7. How reasonable is the stock price as compared to the company’s earnings and intrinsic value? (Great business bought at an expensive price is often a disaster too)

Do just this, and you should be fine with your stock investing.

There is no need to rack your brain with 20 pieces of information when now you know that the maximum capacity is just four, or maybe seven. If you are trying to go beyond that, you are just overloading the most important piece of hardware that resides right on top of your eyes that are reading this.

A Few Stories You Shouldn’t Miss

• Field Guide to Investing – Neeraj Marathe (CFA Society India)
• Aren’t we smart, fellow behavioural scientists (Jason Collins)
• Can we escape from information overload? (The Economist)
• The Virus Will Win (The Atlantic)
• We have slashed and burned the core features of childhood (Washington Post)
• Four Weddings & A Funeral (Scott Galloway)

From My Inbox
Question – Shouldn’t the only reason for ever owning a share of a company be to receive dividends? No matter how valuable a company but if it never or rarely pays out dividends why should the share ever appreciate in value? It is ultimately of no use to its owner. This is analogous to owning physical gold, isn’t it? ~ Prakash

Answer – Thanks for asking, Prakash. Regarding your first question, even when a company is not paying dividends and thus retaining all of its earnings, if the managers are allocating capital well and earning a return (ROE, ROCE) that is more than their cost of capital, the intrinsic value of the business should keep rising gradually. That will show up in stock price appreciation too over the long run. This is unlike gold, where there is no intrinsic value or its growth and the final price depends on what the buyers are paying and sellers are willing to sell at.

So, a company that reinvests its capital well is worth investing into at an appropriate valuation.

A stock appreciates not just when the company pays dividends out of its own cash, but especially when the company is reinvesting well what it does not pay out.

A Question for You
A simple gesture is enough. Give your family member a phone call. Cheer your friend up. Read out to your child. Start by helping the people in your life. And then ask them to pay it forward.

Ask yourself – How can I help one person today?

* * *
That’s about it from me for today.

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Have a great weekend. Stay safe.

With respect,
— Vishal