Base Rate Investing: The Smart Investor's Secret
Where Psychology Meets Profit
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Dear Investor,
When I began investing in stocks around 20 years ago, I fell into the common trap of getting too caught up in a company's story. This strategy works fine as long as the story holds up. But the moment any flaws in the story appear, everything falls apart even quicker than it was built.
It took me years to understand that the fundamentals really move stock prices. Once I shifted my focus to choosing stocks based on solid fundamentals, my profits increased.
However, being naturally curious and always on the lookout for improvements, I still felt something was missing.
Unable to find the right investment approach, I ended up creating my own strategies (Surprisingly, I later found these same strategies discussed in academic papers). This led me to ponder if statistics could enhance investment decisions.
Despite its low popularity among investors, this approach has been quite successful in gambling and sports betting, like card counting in blackjack, for instance.
What if investors viewed the stock market through the lens of probabilities, treating it more like a game of chance? How might they adjust their investments based on the odds?
This question sets the stage for today's topic.
Base Rate Investing
Base rate investing is an approach to making investment decisions that rely on statistical data to assess the probability of an investment's success.
This method is based on the concept of the base rate fallacy, which is a tendency in decision-making to ignore base rate information (general information) and focus on specific information (information only about the case at hand).
In investing, this fallacy can lead people to overestimate the significance of recent events or specific news about a company, while underestimating the importance of long-term, general trends.
By focusing on base rates, investors aim to correct this bias. They look at how similar investments have performed under similar conditions.
For example, if considering investing in a tech startup, an investor might look at the historical success rate of similar startups in the same industry, at the same stage of development, and possibly in the same geographical area.
This base rate then serves as a benchmark to evaluate the expected success of the current investment opportunity.
Base rate investing encourages a more disciplined, data-driven approach, reducing the impact of emotional reactions to market news or events. It aligns with principles found in behavioral finance, which studies how psychological influences and biases affect the financial behaviors of investors.
By considering the base rates, investors can make better decisions, taking into account the broader statistical realities of investment outcomes. This doesn't mean ignoring specific information about the investment opportunity; rather, it means integrating this specific information with the base rates to form a more balanced and comprehensive view of potential risks and returns.
Inside View vs. Outside View
Imagine you're trying to guess how many candies are in a big jar. There are two ways you could make your guess:
The Inside View: This is like looking at the jar and thinking only about what you see right before you. For example, you might think, "This jar is huge, and candies are small, so there must be many candies in there!" This view focuses on the specific situation and details you're directly observing or know about.
The Outside View: This is like stepping back and thinking about how many candies were in other jars you've seen before that were about the same size. Instead of just thinking about this one jar, you remember, "Last time I saw a jar this big, it had about 100 candies." This view doesn't focus on the jar's details in front of you but on what happened in similar situations in the past.
In scenarios where luck has minimal influence and you're privy to all critical information, the inside view becomes more significant. This is similar to a situation where a congress member makes stock trades before passing laws that will affect those stocks 🙃.
Conversely, in scenarios where luck has a greater impact, especially when you lack insider knowledge, incorporating the outside view is crucial to gaining a more comprehensive understanding.
How does this framework work in practice when analyzing stocks?
Well, it’s quite simple.
You can apply this framework to almost every metric/ratio when forecasting a company’s future.
You've discovered a young company with a net profit margin of 30%, while the average for its industry hovers around 10%. It's reasonable to anticipate that, over time, this company's net profit margin will move closer to the industry average, unless the company proves to be an exceptional outlier.
A company is currently trading at 50x Sales. Historically, how frequently have stocks maintained such high trading multiples? And how often did their valuation reverse to the mean?
A CEO declares an ambitious target to increase sales by 30% annually over the next decade. A standard approach by a Wall Street analyst would involve a detailed bottom-up analysis, examining the company's product lineup, potential market size, and achievable market share. However, a reader of this newsletter would take a different approach, questioning the feasibility of such growth by comparing it with similar cases in an appropriate reference class, considering factors like the company's current market capitalization, its industry, and the distinctiveness of its product.
A company is experiencing consistent growth in Free Cash Flow (FCF) year over year, yet its stock price remains stagnant. Typically, since a stock price often aligns with FCF trends, this scenario could present an attractive buying opportunity.
A company sells exciting software and Wall Street is in love with it and sends the stock higher and higher, but the debt is getting out of control? Guess how this will end? The same way it has ended for all companies that were Wall Streets darlings but couldn’t produce any internal fuel (Free Cash Flow) to keep the business running.
You get the idea.
Bonus Tip
Not only can you apply the base rate to an external reference class, but you can also use it within the company itself.
This method has been a part of my toolkit, especially when a company announces initiatives like a "restructuring plan" or a "5-year innovation plan."
I evaluate their history with similar strategic plans, and check their execution success and forecast accuracy. This approach helps me form a clearer expectation for their current plans.
Here, the reference class is the company's management and their track record in similar past situations.
Final Thoughts
Investing requires a holistic approach.
Unfortunately, many investors concentrate too much on the detailed, inside view and overlook the broader, outside view.
Blending these perspectives yields the most effective insights because it offers a comprehensive view of a company. This underscores the importance of understanding stock market history for investment success.
New investors often seek quick results, not recognizing that building knowledge and experience takes time. It's after several years that you'll become adept at forecasting a stock's movement, thanks to your accumulated experiences (your reference group).
With this in mind: Keep reading this newsletter, as I'll share more valuable insights in upcoming articles.
If you want to dive deeper into this topic, there’s a great book called The Base Rate Book from Michael J. Mauboussin, you can read it here.
Until the next issue (I have some big announcements for you). 👋
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Disclaimer: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from my research. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.
I always admire Mauboussin's thoughts!
thanks for the info!