Value Investing, the Chetan Parikh Way – Part 3

I recently had the privilege of meeting one of the highly regarded value investors in India, Mr. Chetan Parikh in his office in Mumbai.

After publishing Part 1 and Part 2 of his interview recently, here is Part 3.

Safal Niveshak: Do you think it’s important to do historical research looking back at companies in different circumstances and understanding or trying to draw conclusions about why they succeeded or failed in a particular decade or period of an economic cycle or change in leadership? Is historical research an important part of your investment methodology or not so much?

Mr. Parikh: In trying to answer the question, I’m reminded of George Bernard Shaw’s remark that when an historian had to rely on one document he was safe, but if there were two to be considered he was in difficulty, and if three were available his position was hopeless.

More seriously, as investors we should take the “most unhistorical view” that can be taken on history and see it some propositions about the future are possible based on the study of past data and events.

And to do so well, the investor must do what the historian is usually not called upon to consider – what might have happened if circumstances had been different.

For as Andre Maurois, the French author wrote: “There is no privileged past… There is an infinitude of Pasts, all equally valid.” (Another quote of his which I really love is, “Business is a combination of war and sport”).

The great trap that an investor can fall into when looking at the past is to underplay the role of chance and contingency and in the process of trying to assign causes to past events fall prey to a kind of determinism stemming from the hindsight bias and the narrative fallacy.

And history selects the winners, so there is a large amount of “selection bias” in historical data which can lead to erroneous probabilistic judgements about the future.

The historian Niall Ferguson put it well…

Historians should never lose sight of their own “uncertainty principle” – that any observation of historical evidence distorts its significance by the very fact of its selection through the prism of hindsight.

I would agree with Mr. Ferguson that the correct way of looking at historical data is through the lens of “chaostry”.

Causation can lead to unpredictable outcomes. Moving the line of the present back in the imagination is no easy task psychologically.

I do look very carefully at past annual reports of a company and changes in the industry structure.

I am fascinated by the notion of history as a cyclical process, so behavior of pricing actions, margins and volumes in different phases of the business cycle always interest me. So do historical valuation multiples.

But I try to avoid being blinded by them or using then in a semi-mechanical manner.

Human nature does not change very fast so past managerial actions with respect to capital allocation and corporate governance could have some predictive value.

You can never make sense of the present without looking at the past. The risk comes from extrapolating the past into the future, especially when regime changes have happened.

Safal Niveshak: Compared to when you started investing, the sheer amount of irrelevant information faced by investors is truly staggering today. Today we find ourselves captives of the information age. Anything you could possibly need to know seems to appear at the touch of keypad. However, rarely, if ever, do we stop and ask ourselves exactly what we need to know in order to make a good decision.

How can investors trapped by irrelevant information make independent investment decisions? What are the 4-5 factors investors can use to improve the quality of their decision making?

Mr. Parikh: There are many problems of information overload.

One is in missing the signal because of the noise.

As the mathematical genius and game theorist John von Neumann stated: “With four parameters I can fit an elephant and with five I can make him wriggle his trunk.”

A mass of data will make a conclusion look better at the end of the exercise, but it will usually perform worse in the real world.

The second problem is associated with what behavioral economists call “the illusion of knowledge.”

Confidence increases with more information but not accuracy. Herb Simon has written about “bounded rationality” and cognitive limitations to processing information.

The third problem is in becoming part of a “crowd” and the herd mentality that comes with it.

Information is different from knowledge but is often confused with it.

The beginning of wisdom is in the statement that Confucius made: “To know that we know what we know, and to know we do not know what we do not know, that is true knowledge.”

Investors should learn to look for what is important as usually there are not too many things that are important to an investment thesis. It comes from focus and not from a deluge of information.

Investors should spend a lot of time on critical thinking and analysis which means being able to junk an idea into the “too hard” file at the end of weeks of work.

All sorts of fallacies come in the way of logical thinking. Psychologically too it is hard to give in after a lot of effort.

Investors should learn to be unsure about their conclusions and that means always thinking probabilistically and being able to change one’s mind when necessary.

It’s good to have a member of the team argue against the decision at frequent intervals.

I certainly do not support the use of “inside information”, but I do believe that there is information which can lead to better analysis which is not easily available.

This is through what Philip Fisher called “scuttlebutt” and is not usually available in the public domain. It requires time and effort to get and it takes effort to sift what is important from what is not. But in the end it makes a difference.

Safal Niveshak: Do you think individual investors are at a disadvantage compared with the institutions, because of the latter’s huge resources, superior facilities for obtaining information, etc?

Mr. Parikh: On the contrary, I feel that individual investors are at a huge advantage to institutions…

1. No benchmark against which frequent comparisons are made
2. No set asset allocation decisions
3. A time horizon of one’s choosing
4. For most individuals, a much large number of potential candidates for portfolio inclusion because institutions may not want them due to liquidity or size
5. Portfolio concentration which should depend on conviction and not on a rule book
6. Ability to take one’s own decisions and not be part of a committee.

Homework does not require large monetary resources – only dedication, effort and time.