Secrets of our Dragon's Den revealed

Thinking like a scientist will make you a better investor. Here's how to do it.

You might think the research process at Intelligent Investor goes something like this: we have an idea, do lots of work and, after enough evidence has piled up in support of that idea, we finally upgrade to Buy. That's not how it goes. 

We've made more than 500 Buy recommendations since 2001, with average outperformance of 5.0% a year relative to the ASX 200 (see our audited 2017 performance report). A large part of that success is probably due to the 'Dragon's Den' process we've honed over the years, which we use to interrogate new ideas.

The process works because it follows a scientific method. We aren't trying to prove ideas, we're trying to disprove ideas. 

We usually start with an ultra-simple hypothesis about a stock. Some fund managers target complexity but that's not our style. We stay simple for two reasons. First, there are only so many variables we can juggle in our heads at one time. If the investment case can't be summarised on a few PowerPoint slides, it probably won't make the cut. Second, as any car owner knows, increasing complexity correlates very well with things going wrong. If an idea takes 100 moving parts to align before it works out, you're asking for trouble (see A quick investment checklist for selecting stocks).

Think negative

When we have a simple idea – say, that an ageing population should cause ballooning demand for aged care, so it might make sense to buy aged care providers – we then try to disprove it. 

When scientists discover a new drug, they don't go about trying to prove that it works. They use a null hypothesis and try to prove that it doesn't work. The reason is that it's more difficult to prove a positive statement than to prove a negative one. You can look at a thousand red apples and still be unable to conclude ‘all apples are red'. Throw in one green apple, though, and you can say confidently that ‘not all apples are red'. 

Equally, we can never know for sure that a stock is going to do well, but sometimes it can be as easy as looking at one factor – say, the balance sheet – to know it's headed for trouble. In the case of aged care, we found that proposed changes to the regulation of bed licences could cause an explosion of supply from non-profit charities. Rising competition is bad enough, let alone competition from operators who are indifferent to making money. Note that none of this invalidates the positive side of the equation – demand really is set to explode – but that doesn't mean you'll make money.

The Dragon's Den is the climax of our ‘idea killing' process – it's when our analysts get together to poke holes in an investment case or point out unanswered questions that require follow-up research. Ultimately, we're looking for ideas we can't kill – or, more accurately, where we're being adequately compensated for the identifiable risks. Finding a needle in a haystack is a lot easier if you throw out all the hay.

The major benefit to our ‘start simple and disprove' approach is that it's enhanced, not hindered, by what psychologists call ‘confirmation bias' – our tendency to search out and interpret information that's consistent with our pre-existing beliefs. 

You could take any stock on the ASX and dream up a positive growth story for it (and investment bankers frequently do). If you start with a positive assumption, trust me, you'll find reasons to buy or hold. On the other hand, if the job you assign yourself is to kill every investment idea that comes your way, you'll spot plenty of risks that you may not have otherwise seen. 

The trick is to take this generally negative view and pair it with the gambling concepts of ‘expectation value' and mispriced bets. You don't need to avoid all risks, but you do need to earn more on your winners than you lose on your losers.

Intelligent Investor is loading up the van and going on tour in April and May, with events on the NSW central and north coast, the QLD mid-north coast and in PerthAdelaideMelbourneSydney and Canberra. If you'd like to hear us talk about building a portfolio to weather any storm, book your spot here.

You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

Disclaimer
Intelligent Investor provides general financial advice as an authorised representative under the AFSL held by InvestSMART Publishing Pty Limited (Licensee). InvestSMART Funds Management Limited (RE) is the responsible entity of various managed investment schemes and funds and is a related party of the Licensee. The RE may own, buy or sell the shares suggested in this article simultaneous with, or following the release of this article. Any such transaction could affect the price of the share.

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