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Hunches - an investor's friend or foe?

Recs

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November 29, 2006 – Comments (11)

fsc137 wrote the following in a preceeding blog thread, but I found the topic so interesting I thought it best captured in a thread of it's own. Here's what fsc13 wrote (referring to my King of the Hill message at the time about my having learned to never underestimate the power of a good hunch):

"About hunches---those who win because they are lucky often come to believe that luck is with them, and that fortune always smiles upon the deserving, or worse yet they begin to confuse luck and skill. This is a "selection effect". Your hunches, if indeed that is what they are, will likely regress to the mean in future. If, however, they are actually some sort of unconscious calculation then you may continue to succeed. We'll see."

My response:

While it may be self-delusion on my part, I like to believe my hunches are unconcious calculations. As an example, my underperform calls on Whole Foods Market I considered 'hunches'. I didn't do a whole lot of research other than look at the trailing P/E and scratch my head in amazement as I said to myself, "For a grocery store chain?! You must be kidding me!"

While that might not seem like much research (and it isn't), there's more to such a thought, I think, that it at first appears. It includes the knowledge that I've seen the organic food trend come and go before in my lifetime. It includes the knowledge that existing traditional grocers have the size, scale, and logistical infrastructure to easily enter the organic food fray should they choose to (and the fact that they have begun to). It includes the knowledge that people very often overpay for growth, especially with regard to things they personally 'believe in'.

Is that a true hunch? On one hand, I didn't pour through the SEC filings, evaluate management's track record, or even walk into a Whole Foods store to check for myself. On the other hand, when I honestly look at it, my hunch was indeed based on a foundation of at least some knowledge and experience.

That's what I meant when I said 'never underestimate the power of a good hunch'. Intuition is a powerful tool, and while it shouldn't be an investor's only tool, I think many investors will do themselves a disservice if they ignore it.

11 Comments – Post Your Own

#1) On November 29, 2006 at 1:05 PM, Steve819 (97.70) wrote:

Russell,

Good point. One of the things that is very valuable about CAPS is it is a way for experienced and non-experienced investors alike to develop confidence in their inner hunch.

In many cases, if one wants to pick up points on the leaders, we have to venture into somewhat unfamilar territory, and make our call based on a hunch. It has been very interesting to see the results (very positive so far) of how my hunches have played out.

Prior to CAPS, I would have had no idea if my hunch on NMX would have been correct. Now....I get rewarded for making those calls instead of laughing at the market cap and moving on to researching the next great stock.

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#2) On November 29, 2006 at 2:11 PM, TMFEldrehad (99.99) wrote:

I agree with you here wholeheartedly, and for me it goes a good bit further.

Taking your call on NMX, or mine on WMFI, how many times (prior to CAPS) would I have done what you would have done and scratch my head at WFMI's valuation and moved on? Quite a few.

Not only am I being rewarded in CAPS for being correct in my 'hunches', more importantly CAPS gives the the opportunity to 'close the learning loop' which didn't exist before. Before I would have moved on, perhaps never to look at WFMI again in any meaningful way. With CAPS, when I make a 'hunch' a pick, I am forced to take a look back some time later, tell whether my huch was right or not, and more importantly, perhaps gain some insight into *why* it was right, or not.

Granted, CAPS is still quite young, and I've been playing for only about six months or so, but I'm following more companies, industries, and stocks than ever before, learning about them, forming opinions about them, and then looking back and finding out whether or not my opinions were correct or incorrect, and learning even more from that process.

Intuition has always been a big part of how I make all of my decisions (not just investing ones), and CAPS is providing me with a fantasic opportunity to learn how to use this tool perhaps even more effectively. I've found this alone to be an almost immeasurable benefit of CAPS.

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#3) On November 29, 2006 at 2:54 PM, Steve819 (97.70) wrote:

Very well said - that's exactly how I view hunches and CAPS as well.

I too, am learning about many more industries, and forced outside of my comfort zone in an all consuming effort to find undervalued stocks for CAPS. The handy side effect is that I am becoming a better investor, and finding quite a few more interesting stocks that I would have passed over before because the industry is "too hard" to understand or "too boring" to research.

I think that is one of the things that people miss when they complain about huge pick lists (100+) in that the CAPS player can't possibly folow all of those stocks, and darn it, I just want their BEST recs.

Those CAPS players with the huge pick lists are the ones who are acting on hunches, venturing outside of their comfort zone and picking stocks they normally wouldn't care to research, and ACTIVELY learning. I think that is true for you and me, and I wonder if Seth feels the same way.

Sure, I can give you one or two of my best picks, but wouldn't you really want me to take my experience and knowledge, apply it to a new industry, and find another potential double too? I know that would be beneficial to ME, and the nice thing is, CAPS rewards that learning experience too.

Steve

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#4) On November 29, 2006 at 4:53 PM, TMFSpiffyPop (99.30) wrote:

What Russell said.

What Steve said.

You guys get it! (As in "totally," "completely," "quintessentially.") --D

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#5) On November 29, 2006 at 6:44 PM, Persuter (44.11) wrote:

The key here is found in the two quotes. Eldrehad, you said "Never underestimate the power of a GOOD hunch". Well, that's great, but how do we tell what's a good hunch and what's a bad hunch? The answer is in fsc's quote, that your picks "will likely regress to the mean in the future". Well, that would only be true if your hunches were actually based on factors totally irrelevant to a stock's performance. But they're not -- in the specific case of Whole Foods, you compared the trailing P/E to typical P/Es in their industry. That's about as far as you can get from gut intuition -- you could probably use company P/E versus industry P/E as the only stock-picking criteria you had and do pretty well. Good hunches are the ones that go with the odds, and bad hunches are the ones that defy the odds.

My father has played in his office football pool for four years. At first, he paid a lot of attention to the teams, to the players, to sports betting forums, etc. And he lost. Badly. Today, he uses only one factor -- he picks the home team every time. He's spending less time on his picks than anyone -- and winning the pool.

The more complex an analysis is, the more points of failure it has. When I pick a stock, I look at its trailing and forward P/E, its PEG, its assets versus liabilities (and whether they're actual assets or "goodwill"), and its income statements. I consider its position in its industry, and the state of that industry's market in general. At that point, if I'm not convinced, I move on. What's the point of looking for more? There's thousands of stocks out there -- why waste your time searching for the one stock that will defy all the odds? Find a few factors that predict stock performance well and stick with them.

Of course, as you both said, the great thing about CAPS is that you get real feedback with how the factors you're using are working -- without having to do it through trial and error with your own money.

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#6) On November 30, 2006 at 12:22 PM, paologrigio (< 20) wrote:

A well known quote from Gary Player which I think is relevant to the hunch/luck debate:

"The more I practice, the luckier I get."

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#7) On November 30, 2006 at 1:33 PM, sams5940 (47.48) wrote:

TMFE, I just stumbled onto your post since I'm beginning this CAPS thing and saw you rated OSK.

Then I noticed your rank and thought, 'ok, this guy is worth reading.'

well said about hunches and kudos to a winning strategy.

Also, your final sentence reminds me so much of Malcolm Gladwell's 'Blink' that I can't help but ask if you've read it. If not, you two have a lot in common.

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#8) On November 30, 2006 at 1:57 PM, TMFEldrehad (99.99) wrote:

First, thanks for the kind words.

No, I haven't read Gladwell's 'Blink', but maybe I should. :-)

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#9) On November 30, 2006 at 2:19 PM, TMFEldrehad (99.99) wrote:

In reply to what Persuter wrote:

"...in the specific case of Whole Foods, you compared the trailing P/E to typical P/Es in their industry. That's about as far as you can get from gut intuition -- you could probably use company P/E versus industry P/E as the only stock-picking criteria you had and do pretty well."

While one might be able to do pretty well using only this metric, I'm not yet convinced. Often times, there's a very good and real reason why a particular company's trialing P/E is well out of line with that of its peers.

The trick is understanding *why* that metric is out of line. With Whole Foods, I believed the high P/E was due to two main factors. First, I think many people were mistaking a fad for a long-term trend. Second, and more importantly, I think people were underestimating the competitive response from traditional grocers. Given that reasoning, calling underperform on Whole Foods at the time made a great deal of sense.

The trick, of course, is being able to tell the difference between a justified and unjustified multiple divergence.

That said, you raise a good point in that 'hunch' might not have been the best choice of words on my part to describe my thought process. Perhaps intution, or deciding via initial impressions, might have been the better choice.

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#10) On November 30, 2006 at 4:28 PM, sams5940 (47.48) wrote:

Blink isn't a particularly great book (could be much more concise) but the anecdotes are very entertaining. the book begins with a story about a 2000 year old (or so) statue that is uncovered at a dig in near mint condition. It is then sold to a museum in the US for millions of dollars because all scientific tests conclude that it is, indeed, genuine.

however, the scientists all had the same initial 'gut' feel that it was just too good to be true and had to be a fake. regardless, the science said it was real.

As you might guess, it turns it the statue was a fake made in some guy's basement and the museum got ripped-off, setting forth the premise of the book.

I sort of butchered the intro but that's the gist of it, and I just thought the whole book complements your post / strategy very nicely.

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#11) On December 07, 2006 at 8:39 PM, daddylight (32.43) wrote:

Here's my problem with hunches . . .

. . . it's September 1994, you take a look at SBUX and think ttm P/E of 67!? For a coffee shop??

Fast forward 12 years and it's been a 25-bagger. (BTW I have no opinion on SBUX and I've seen yours at 50 P/E so I'm guessing you're consistent at least). Hunches seem a poor tool to separate the Whole Foods from the Starbucks of the world.

I pick these two on purpose as the crux of the valuation for both seems to be: are they selling a fad or a sustained lifestyle? The patrons of Whole Foods do not equate it with Kroegers.

It seems 'hunches' like this are nothing more than shorting growth and going long value based on P/E and CAPS rewards you for doing this on a stock-by-stock basis; calling a 1% move in 100 stocks right gets you 100 points, calling the same move right by shorting a growth index ETF and buying a value index ETF with the same 100 stocks (or more) gets you 2 points.

I know that's how CAPS is played, but as they say 'don't try this at home!' First, it's far less efficient than the corresponding ETFs and second, you'll trick yourself into thinking you're a stock picking genius when in fact you're a poor constructor of indices.

PS. If it sounds like I'm jumping you or am down on CAPS, I'm not. I use CAPS and you in particular as a stock screen as I'm always looking for ideas. I just don't find that many issues mispriced enough to pass Graham's margin of error criterion to justify veering away from indicies and I don't want to make calls in CAPS I wouldn't make with real money - the last thing I need to start doing is deluding myself.

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