On Probability, Observation, and Investing

Investors need to think about exactly what they mean when they use terms from probability. They need to appreciate the role of the observer (and his limited knowledge). For instance, if I flip a coin and cover it before you can see how it has landed, is it really correct to say there’s a 50% chance the coin has landed head-side up?

The problem is that we know that the class of (fair) coin flips will be populated by as many instances of heads as tails; therefore, if we know that a coin flip belongs to the class of fair coin flips (but know nothing else about the special case), we may say that there is a 50% chance the coin will land head-side up.

But, there is one somewhat unsettling matter to consider. Once I have flipped the coin and it has landed, we can all agree that it has either landed head-side up or tail-side up. The event has already occurred. But, it hasn’t yet been observed. Of course, I could lift my hand a bit and sneak a peak. Then, I’ve observed the outcome, but you haven’t.

Speaking probabilistically, you might still say there’s a 50% chance the coin has landed head-side up. But, you would now know that there is a difference between the knowledge possessed by different observers. The unsettling part comes when you realize that a probabilistic statement can not be made independent of the observer (and her knowledge).

It may seem a trivial problem when we consider the observer to be a single individual. But, all our knowledge is dependent upon observation, and all our probabilistic statements are dependent upon our knowledge – so, all of our probabilistic statements are dependent upon our knowledge.

That’s obvious, because we only make such statements where our knowledge is limited (we know something about the class but not the special case). The problem for investors is that two analysts with the same data may interpret that data differently such that they arrive at two very different conclusions. Essentially, they will make two different probabilistic statements (largely based on what data they believe pertains to the special case in question).

For instance, you can make a statement about stocks trading at a P/E of 12, or stocks trading below book value, or stocks that have achieved a ROE of greater than 15% in nine of the last ten years. But, that may not be the best class to consider.

I just mentioned Harley-Davidson (HDI) in a previous post. Does Harley-Davidson belong to the class “stocks with a P/E of 15”? Or, does Harley belong to the class “stocks of companies with entrenched consumer brands”? After all, some stocks with a P/E of 15 may be in commodity businesses.

The investor needs to reference several different past records at once. She needs to consider the past record of entrenched consumer brands (how many had their earnings power diminished? How many of the brands lost their luster? …

Off Topic: On Cause and Effect and Inherent Randomness

This is an off-topic post (i.e., it doesn’t pertain to investing). Below, I have reprinted a comment written in response to my post On Technical Analysis and my response to that comment.

Amanda Gerrish writes:

Good article. However, I must take exception to your idea that there are no truly random events in nature. Quantum physics proposes that all quantum processes (sub-atomic events) have an inherently random element. These events are not apparently random because we don’t have enough information, or we don’t have the correct model. They are inherently uncertain. At best, we can assign probabilities. Since all macroscopic events (including human actions, markets, the weather, etc.) are built upon microscopic (sub-atomic) events, this implies that there is an inherent, irreducible uncertainty or randomness to all events. Well, at least, if you believe quantum mechanics.

My response:

You make a good point about quantum mechanics, but I have seen it taken too far. For instance, one philosopher argued that an inherently random element supports the case against the existence of God (or a prime mover of any sort). I have a few problems with this argument. The biggest problem is that it favors accepting the existence of an uncaused event over the prudent course of withholding judgment because far too little information is known.

When I say far too little information is known, I mean simply this: an inherently random element does not fit with the law of cause and effect. So, we have three options. One, we could throw out the law of cause and effect and assume that the best we can ever do is establish correlative rather than causal relationships. Two, we could throw out the idea of an inherently random element in quantum mechanics. Or, three, we could withhold judgment, because we feel our understanding of these matters is insufficient.

I favor the third course, largely because I think our understanding of time remains inadequate. In several different places, the study of physics has bumped up against our ignorance of what time really is, and just how it works in the extremes. This gets us into some very strange sounding discussions. However, we will need to address them eventually.

Are there more dimensions than we perceive? Is our perception of time flawed? Can actions occur outside of time? Is any “inherently random element” actually the result of a cause that did not occur in the dimensions we perceive? Simply put, is it possible we can’t perceive the cause, or even the general laws under which the cause operates, and therefore can not conceive of the effect as being anything but random?

I wouldn’t put it into these words, but I think eventually people will say that it’s possible there may be causes operating “outside of time” – simply meaning that there may be causes that do not operate according to the principles of time as we know them. As strange as it sounds, I think the logical idea of …

News Item: Harley-Davidson (HDI)

In early April, Harley-Davidson (HDI) will open its first dealership in China amid a flurry of festivities. Harley-Davidson named Beijing Feng Huo Lun as its first authorized dealer in China. The dealership, located just outside downtown Beijing, will have a staff of 14. It will operate under the Beijing Harley-Davidson name.

The dealership will sell Harley-Davidson motorcycles, parts, and accessories. Harley-Davidson apparel and collectibles will be sold as well.

Harley-Davidson’s management believes the move into China represents a long-term opportunity. Progress will be gradual. Ownership and riding restrictions remain impediments to the company’s growth. Disposable income is still too low in China to support a large “premium, heavy-weight” motorcycle market. The company hopes that ownership and riding restrictions will be reduced as disposable income continues to grow.

On Friday, Harley-Davidson’s share price rose $1.88 to $51.07. At their closing price, shares of Harley-Davidson offered a 6.68% earnings yield.

Over the last ten years, Harley-Davidson’s book value per share compounded at a 17.78% annual rate. During that same period, annual EPS growth was 21.92%.…

New Podcast: “Buffett Businesses”

Listen to the Gannon On Investing Podcast: “Buffett Businesses”

A new podcast episode entitled “Buffett Businesses” is now available. This podcast wraps up Buffett week.

Enjoy the show.

Summary: The entire show is a discussion of the kind of business Warren Buffett looks to invest in. The discussion focuses on owner’s earnings, return on equity, and earnings growth.

Run Time: 29 minutes

Next Show: “Work Habits”…

Value Investing Directory: New Additions

Visit the Value Investing Directory

Navigation

The “Navigate Directory” section will remain at the top of your screen after you pick a new category. To navigate the directory, simply click on a category and then scroll down to see the listings within that category.

After you click on a category, the “category tree” will remain at the top of your screen; however, the listings below will change. Therefore, you need to remember two things: 1) Scroll down to see the listings 2) Choose “deeper” sub-categories to refine your search. For example, there are fewer listings in Blogs > Investing Blogs > Value Investing Blogs than there are in Blogs > Investing Blogs, because all value investing blogs are also listed as investing blogs.

The directory now includes 5 new listings. First, let me discuss the submission process. Then, you can view the list of new additions.

Submissions

To submit a site for inclusion in the Value Investing Directory please send an email to [email protected] with the site’s URL. All submissions will be evaluated within 48 hours; however, most submissions will be rejected.

Prospective sites are evaluated on the basis of utility alone; neither reciprocal links nor payment is required. Linking to the Value Investing Directory (or any other part of the Gannon On Investing website) will not affect the evaluation process.

If you would like to propose a new category, request a change to your site’s listing, or request the removal of any site, please send an email to [email protected]. All reasonable requests will be considered; however, I reserve the right to list and describe sites in whatever manner I deem to be most useful.

New Additions

Personal Favorites: Seeking Alpha, Wall Street 2.0

Worth a Look: pfblogs.org, Phat Investor, Rule #1 Investor

All new additions by category:

Resources

Online Resources > Value Investing Sites > Rule #1 Investor

Online Resources > Blog Aggregators / Networks > Phat Investor

Online Resources > Blog Aggregators / Networks > pfblogs.org

Online Resources > Blog Aggregators / Networks > Seeking Alpha

Online Resources > Blog Aggregators / Networks > Wall Street 2.0

Visit the Value Investing Directory…

Widest Moat Contest: General Electric Defeats Johnson & Johnson

General Electric (GE) defeated Johnson & Johnson (JNJ) in the most recent round of the Widest Moat Contest voting. I was surprised by how wide the margin of victory was. They were both very good picks.

Once again, I received some excellent email votes. Remember, the person who picks the company that ends up winning the contest isn’t the only one who will win a copy of Benjamin Graham’s Security Analysis. The author of the best email vote will also receive a free copy of Ben Graham’s magnum opus.

Thank you to everyone who voted.

The Widest Contest will end with a true clash of titans. The three finalists are General Electric, Coca – Cola, and Microsoft. You can vote for one of these companies right now. I will accept votes submitted as comments to this post as well as email votes.

This final round of voting will conclude at 11:59 p.m. on Monday. The winner of the contest will be announced on Tuesday. At that time, I will also select the best email vote of the contest.…

Suggested Link: Wall Street 2.0

Visit Wall Street 2.0

I’d like to introduce you to a new investment blog network called Wall Street 2.0.

Three of my favorite blogs (Absolutely No DooDahs, The Enterprising Investor, and The New Wall Street) are part of the Wall Street 2.0 Network. Wall Street 2.0 is an invitation only network of investment blogs. Each of the blogs has a clean, uniform look. The content is, of course, anything but uniform. The network also includes message boards.

Wall Street 2.0 plans to add additional blogs over time. But, the network will remain selective. I highly recommend this fine collection of investing blogs.

Visit Wall Street 2.0…

Widest Moat Contest: General Electric, Microsoft, or Coke?

The three finalists in the Widest Moat Contest are General Electric (GE), Microsoft (MSFT), and Coca-Cola (KO). The tally so far: Microsoft (2), Coca-Cola (1), General Electric (1). Your vote could make the difference. Vote by clicking the “comments” link at the end of this post.

MarketWizWannabe votes for GE:

Basically, every “product” business that GE is in has a moat – aircraft engines, plastics (think, lexan), locomotives, nbc, power systems (turbines / nuclear systems), and healthcare (MR / CT products). They’re #1 or #2 in all of those products worldwide. That’s a pretty wide set of moats, and it gets my vote.

S. Chin votes for Coke:

My vote is for Coke. GE’s and Microsoft’s moat keep enticing a lot of competitors. Everyone wants to “extend” their brand into their markets like Google, Yahoo or Oracle. Microsoft is the incumbent, but there’s so many people knocking on their door. Same with GE — their financing division also has people reducing their margins and attacking them. NBC always has new lineups from FOX, CBS and cable. When is the last time someone tried to extend in the cola industry successfully. Snapple, Gatorade all tried, but never became a serious threat to the whole franchise. Although, there’s private label items – Coke continues its dominant market share, with a product that 1) does not become obsolete or outdated and 2) requires huge capital investments to produce. Plus, Coke’s has a longer track record… it has several World Wars and recessions under its belt and still going strong. Coke hands down.

Henry votes for Microsoft:

Out of the final 3 companies (GE, Coca-Cola, Microsoft), I’d like to vote Microsoft as having the widest moat. Their monopoly in multiple areas in the software industry is phenomenal. In addition, many people still aren’t aware that they are the biggest R&D; spenders in the industry as well. Microsoft today is no longer a pure software company and will expand rapidly into other areas.

Grant votes for Microsoft:

General Electric has the best managers in the world, Coca-Cola, one of the best brands, but what about Microsoft? It has a complex product with a large installed user base. It is not the fact that its product is complex that digs the moat, but that its intricacies are engrained with so many users.

If you are looking for a turbine, household appliance, or TV channel there are alternatives to suggest. Want a cold non-alcoholic beverage? There are some choices. Suggest to your company to stop using Windows and Office and you would be laughed at. That may be granting too much. The majority of people in the office work environment most likely cannot even imagine using a computer without Microsoft’s products.

Let us know what you think.

Who’s right? Who’s wrong? And which company has the widest moat?

Vote by clicking the “comments” link below.…

Widest Moat Contest: General Electric vs. Johnson & Johnson

The penultimate round of the Widest Moat Contest is a face-off between General Electric (GE) and Johnson & Johnson (JNJ). Which company has the widest moat? Send your vote via email; or, if you’d prefer, vote by commenting directly to this post.

The voting closes at 11:59 p.m. tonight.

Why should you vote? Obviously, to share your opinions with others, and to engage in a thoughtful debate about the competitive advantages of different businesses. But, for the less altruistic listener, there is one other reason to vote:

You can win a copy of Benjamin Graham’s “Security Analysis” (1940 edition)

The listener who sends in the most interesting email will win a copy of Ben Graham’s “Security Analysis”.

To hear the rationale behind the two picks listen to the Gannon on Investing Podcast: “Buffett’s Letter”…

On Google Finance

Google Finance launched yesterday. I have mixed feelings about the service. It looks to be a great finance portal. But, finance portals still have a lot of room for improvement.

Google finance begins with search. You enter the name of a publicly traded company into the familiar Google search box. The search is not limited to ticker symbols. Entering either the ticker symbol or the company name will immediately load a company page.

Entering a term like “restaurants” will return a list of relevant stocks and funds (in this case, 2,168 companies and 1 fund). A few of these companies are private; but, many are publicly traded.

The search results for generic terms (like restaurants) are fascinating. There seems to be a bias towards large cap stocks. By this I mean that large cap stocks that are somewhat related to the search term often get placed above highly relevant, smaller companies.

Google Finance’s search feature is very weak. Obviously, it’s an improvement over the other finance portals; but, the generic search feature is badly flawed. For instance, neither Electronic Arts (ERTS) nor Activision (ATVI) is among the top ten results for video games. On the other hand, terms like steel work pretty well.

If the search term isn’t in the company’s name or the company is engaged in more than one industry, the results tend to be very poor. The search feature can’t really be used as an industry search unless you know the exact term that will work best. For instance, you’d have to know to use waste instead of garbage or trash; and poultry instead of chicken. It’s not exactly intuitive.

Some search terms will lead directly to a company page. This is a wonderful feature that lets you find a company without having to know the ticker. Here, Google Finance gets a little cocky. It’s always convinced it knows exactly what you’re looking for, even when it clearly doesn’t have a clue. For instance, the search term “video games” returns Navarre Corporation (NAVR). There are two problems with this. Obviously, a generic term like “video games” should not return a specific result. Also, while Navarre Corporation is a relevant result for the search term, it isn’t even close to being the most relevant result for “video games”.

Google Finance’s search feature doesn’t seem to be able to consistently return subsidiaries. This is very unfortunate, because my first thought upon seeing the Google search box was that users would be able to perform true subsidiary searches. That doesn’t seem to be the case – yet.

For instance, a search for Kentucky Fried Chicken returns Kentucky Fried Chicken Japan instead of YUM! Brands’ KFC corporation division. On the other hand, a search for Duracell does return the maker of the CopperTop. Strangely, Duracell’s (public) parent Procter & Gamble (PG) is not listed in the related companies section of Duracell’s company page.

These are understandable mistakes for a computer to make. But, …