Can we use heuristics to analyze a business?

Investment decision making

Decision making under uncertainty

A lot of decisions we make as investors are essentially judgement calls. For example, we want to know the future prospects of a company before putting a lot of our hard-won dollars into it.

If investing was like putting money down in a roulette game, we could calculate the probabilities of winning with certainty. But things like the future of the private automobile, the security of a supply chain based in Vietnam, the evaluation of a company’s business franchise and business prospects or how skillfully management will take care of the enterprise are, in essence, uncertain. This post is about decision making under uncertainty.

Analysts make a noble effort with their models and impressive spreadsheets projecting, five or even ten years in the future. The problem with spreadsheets is that the validity of the analysis depends entirely on the assumptions made. And these assumptions are typically based on intuition, or a judgement call about something that is uncertain. Is there a better way?

Imagine a company that has paid a dividend faithfully for the last ten years. We could select the company because it is a dividend aristocrat and because it is in a sector we want to invest in. Making an investment decision based on the dividend record is the use of a heuristic as we will see in a moment.

Before we go further, let’s look at a few thoughts from Warren Buffett to set the scene.

Thoughts from Warren

Warren Buffett says that his attitude when buying a common stock is to “approach the transaction as if we were buying into a private business…. When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. 1998) p.63 (Emphasis added)

Another quote from Buffett gives us guidance as to where we should be looking. At the 2016 Berkshire Hathaway Annual Meeting, Warren Buffett said: “We’ve made plenty of mistakes in acquisitions. Plenty. And we made mistakes in not making acquisitions, but the mistakes are always about making an improper assessment of the economic conditions in the future of the industry of the company.”

He added: “What counts is whether you’re wrong about — whether you’ve really got a fix on the basic economics and how the industry’s likely to develop, or whether Amazon’s likely to kill them, you know, in a few years, or that sort of thing.” Further, what was important was “assessing the future economic prospects of the business.”

And here’s the rub. The future prospects of any industry or sector or business is always uncertain. There is no way to calculate probabilities about these future prospects. Buffett uses business judgement based on years of experience. It’s basically a learned intuition.

As George Akerlof and Robert Shiller put it: “…decisions that matter for investment are intuitive rather than analytical.” (Akerlof & Shiller, Animal Spirits. 2009) p.144. What they are saying is that, at its core, every investment decision is a judgment call based on learned intuition.

Decision making under uncertainty

In the early 1970s, Amos Tversky and Daniel Kahneman, two Israeli psychologists, started working together on the subject of people’s attitudes to risky choices. One of the main focuses of their work over many decades was decision making under uncertainty. Ultimately Kahneman, following the death of Tversky, became a recipient of the Nobel Prize in Economic Sciences. Tversky would undoubtedly have shared the prize had he been alive.

Daniel Kahneman writes that: “…the accurate intuitions of experts are better explained by the effects of prolonged practice than by heuristics. We can now draw a richer and more balanced picture, in which skill and heuristics are alternative sources of intuitive judgements and choices.” (Kahneman, Thinking, Fast and Slow. 2011) p.11

Skillful expert intuitions vs heuristics

There is a world of difference between the intuition of an expert like Warren Buffett that comes from prolonged practice and an intuition that comes from a heuristic. The latter is much more fraught with potential for error.

So, what is a heuristic?

It was Tversky and Kahneman who developed the idea of heuristics.

Kahneman reminds us that we regularly make very quick intuitive decisions. Let’s say we see a candidate for political office on TV. We might decide pretty quickly if they are going to get elected. We might decide based on how they look or how they answer one or two questions. A political analyst might spend quite a bit of time looking at the polls, the potential political pitfalls for the candidate and would likely come up with a more reliable answer as to whether the candidate will get elected. But, often our quick intuitive decisions are bang on right. But often enough they are wrong.

Kahneman says a “heuristic is a simple procedure that helps find adequate, though often imperfect, answers to difficult questions.” (Kahneman, 2011) p.98

As an example, Kahneman tells the story of a visit he made to the chief investment officer of a large financial firm. Kahneman says “[he] told me that he had just invested some tens of millions of dollar in the stock of Ford Motor Company. When I asked how he had made that decision, he replied that he had recently attend an automobile show and had been impressed. “Boy, do they know how to make a car!” was his explanation. He made it very clear that he trusted his gut feeling and was satisfied with himself and with his decision”

The investment officer had been faced with a difficult decision. A proper business analysis, along the lines of what Warren Buffett suggests, looking carefully at the likely development of the automobile industry and Ford’s prospects in it, would have been a difficult question to grapple with. The investment officer seems to have substituted an easier question – ‘do I like Ford cars?’

Perhaps the investment officer had a stock analyst’s report as well. But it is credible that his decision ultimately came down to what he thought of Ford cars.

Kahneman writes: “This is the essence of intuitive heuristics: when faced with a difficult question we often answer an easier one instead, usually without noticing the substitution.” (Kahneman, 2011) p.12

The power of common knowledge is a slippery slope

Was the investment officer way off base?

Peter Lynch’s book, One Up on Wall Street was a best seller for good reason. It is written in a lively style and is packed with great investment ideas. One of his key observations is what he calls ‘the power of common knowledge’.

He puts it this way: “During a lifetime of buying cars or cameras, you develop a sense of what’s good and what’s bad, what sells and what doesn’t. If it’s not cars you know something about, you know something about something else, and the most important part is, you know it before Wall Street knows it. Why wait for the Merrill Lynch restaurant expert to recommend Dunkin’ Donuts when you’ve already seen eight new franchises opening up in your area? The Merrill Lynch restaurant analyst isn’t going to notice Dunkin’ Donuts (for reasons I’ll soon explain) until the stock has quintupled from $2 to $10, and you noticed it when the stock was at $2.” (Lynch, One Up on Wall Street 1989,1990) p.23.

At first blush, on reading Lynch, one might suppose he is advocating “Boy, do they know how to make a car!” style investing.

But, and this is critical, Lynch makes it clear that finding a promising company is only the first step. The investor has to investigate the company’s finances and do other homework. I suspect this more mundane (less fun) advice is often ignored.

Danger of confirmation bias

What we learn from Daniel Kahneman is the danger of these initial impressions and intuitions. We don’t realize that the product has caused us to jump to a conclusion about the investment merits of the company. A preconception sets in, and we start seeing facts and data to support that decision. The preconception will be hard to shake.

Conclusion

The question I started with was whether we can use heuristics to assess the future economic prospects of a business. The answer is that in investing we use heuristics at our peril. The heuristic might give the right answer, but it might lead us astray. Where a judgment call is required, it is best to call on expertise we have developed over the years.

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Topic add-on

There are things that are called heuristics that really aren’t. I will explain.

In a stimulating and useful book titled Risk Savvy, How to Make Good Decisions, published in 2014, Gerd Gigerenzer writes: “A rule of thumb, or heuristic, enables us to make a decision fast, without much searching for information, but nevertheless with high accuracy” p.29.

The story he recounts to illustrate this point is the remarkable account of how in 2009 Captain Chesley Sullenberger brought a disabled U.S. Airways flight to a safe landing on the Hudson River after both engines were knocked out by a flight of Canada Geese.

When the engines died Sullenberger had to make a fast decision whether he could glide without power and reach LaGuardia airport. If not, he was going to have to ditch somewhere.

He could see LaGuardis through his windshield. Pilots are trained that, when gliding, if an airstrip in view appears to rise in the windshield, the plane won’t make it to the runway. If the apparent height of the airstrip stays the same or even appears to sink in the windshield view, they will make it.

Gigerenzer calls this the gaze heuristic. Respectfully, I don’t think this is a heuristic at all. It is a simple physical fact that can be proved mathematically. It is not a judgement call. It is not intuitive. It does not deal with an uncertain future outcome.

Gigerenzer says it’s the same rule of thumb used by outfielders in baseball. When they are running to catch a pop fly, they simply keep the arching ball on a constant angle. The ball and the fielder are two objects moving towards each other at different speed and trajectories.

I am well aware of this ‘rule of thumb’ or physical fact through my sailing. Sailors and anyone with experience handling boats and ships knows that if two vessels are approaching each other on an angle at different speeds, if the angle remains the same, a collision will occur. The other boat might be 30 degrees off my bow, or 120 degrees off my bow. If the angle stays the same, I must take evasive action. There is no uncertainty.

As noted above, a heuristic is answering an easier question. But it is only a heuristic if it may or may not lead to an answer to the difficult question. The rising or lowering of the runway in the windshield is simply geometry at work.

The notion of the gaze heuristic seems to have spread.

In an article titled We don’t have a hundred biases, we have the wrong model, published July 21, 2022 Jason Collins proposes that psychologists adopt a new model of human behaviour. It’s a good read and full of great ideas. For paper see here.

But, at one point he writes: “A human decision-making example is the gaze heuristic, a tool that people use to catch balls. The heuristic is simply to move so that you maintain the ball at a constant angle of gaze. This will take you to where the ball will land.”

You can look the gaze heuristic up on Google and it even has an entry in Wikipedia. While it may be a valid quick check in a fast-moving situation, it is not a heuristic in the sense explained by Daniel Kahneman. For Sullenberger, the moment the LaGuardia runway appeared to rise in his windshield, he could be certain of not making it.

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Can we use heuristics to analyze a business?

Decision making under uncertainty

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Decision making under uncertainty

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