One of the key elements to investing is to figure out what you know that the market is missing. The efficient market hypothesis taught in academia is incorrect. It states that all available information on any stock is available to the market as a whole and is continually reflected in its stock price. If that were true, we’d see a lot less volatility and wouldn’t see such a wide disparity of returns between individual stocks. While most people aren’t wrong about everything all the time, there are situations where the market’s dominant narrative is incorrect. Let’s go through three examples of these situations and discuss how I’ve either solved them or applied proxies for knowledge.
1) It’s obvious everyone is wrong:
These situations are uncommon and it’s dangerous to assume that everyone else has the wrong opinion. However, uncommon doesn’t mean impossible. Two of these situations were present during Covid. In 2020, DKI bought $HCA when many thought the company would go bankrupt. We knew that wouldn’t happen.
The dominant narrative was that Covid was shutting down hospitals and the only treatment available outside the emergency room was for Covid-related illness. That meant the high-margin procedures like knee and hip replacements were being delayed. It was obvious to us that the idea that all of the high-end medical facilities in the US were going to be focused on Covid 100% of the time made no sense. People delayed cancer and cardiac treatment to the detriment of their long-term health. People delayed hip and knee replacements to the detriment of their long-term comfort. It just didn’t make sense that our hospitals were going to be all-Covid all the time. The dominant assumption was so wrong that a quarter or two after the US government gave HCA $5B to ensure they didn’t go bankrupt, the company returned the money to the government. We made more than 100% on our investment in approximately a year.
$HMHC was another example. In 2021, company results were weak as school boards didn’t meet to select new school books. No new school books meant a lack of new sales. The stock traded like the company was experiencing permanent impairment. Again, common sense said otherwise. There was no reason to believe the US educational system had decided it was done ordering new textbooks. In addition, new higher-margin products focused on individual learning and tutoring were about to become more necessary as students got very little instruction while attending school via Zoom.
Conclusion: In both of these situations the stock market assumed a situation that HAD to be temporary would represent a permanent impairment of the business. To determine this was less a matter of detailed research and more a matter of thinking through what outcome was reasonably possible.
2) Detailed Research Provides Clarity:
Many years ago, when Raji Khabbaz and I were running Silver Arrow, we were looking at the cruise line stocks. We liked the business, but the stocks had traded down due to the perception that new capacity entering the Caribbean market would lead to meaningful price cuts. Not only were there new boats in coming in the most important cruise market in the world; but also, the new ships were much larger than their younger cousins. Raji had reasonable concerns that weaker pricing and reduced occupancy would hurt financial results in the next 2-3 quarters.
I spoke with company management and they all assured me that business was good and that they thought the big Caribbean market had enough demand for the coming supply. Raji was unconvinced simply replying, “but how do we know?” It was the right question. Management almost always tells you the good version of the story.
So, I got in touch with the Caribbean Tourism Agency and spoke to the people on the ground there. Their entire job is to track supply and demand trends for this exact market. They had an interesting response saying that on a percentage basis, the new capacity additions were consistent with prior years. While the new boats were larger than the old ones, looking at the relative increase in overall capacity, the addition wasn’t out of line with prior years. They concluded that there was plenty of demand for the coming supply. Raji again responded, but how do we know? And again, this was a reasonable and important question.
I kept thinking about how I could prove whether new capacity was an issue or not. Eventually, I realized the answer was available and that no one was seeing it.
As a result of our interest, I had been spending a lot of time on sites like iCruise.com and CruiseCritic.com. I could see details about the new ships, their deck plans, their capacity, the itineraries, and lots of commentary from frequent cruisers. Then, I saw it…The new ships expected to be put in the water in the coming quarters were ALREADY taking reservations for their first year’s sailings. The new capacity was ALREADY IN THE WATER and being sold in the market. While the ships may have still been in dry dock, the reservations systems were booking people who wanted to be early passengers on the new ships.
The market had absorbed the new capacity already. Management was right. The Caribbean Tourism Agency was right. And most importantly, we now knew with certainty that there were no capacity-related price cuts coming. We bought $RCL and $NCLH, both companies announced fantastic quarters featuring higher pricing and packed occupancy. The stocks rose, and we made money for the limited partners of our fund.
3) You Can’t Know, but There’s a Proxy:
For this one, I’m going to use a personal example. DKI readers know I had surgery a week ago to repair three hernias. I’m healing well. The procedure went well and without complications. I received a high level of care from the surgeon and the hospital staff. But…To quote Raji, “How do we know?”. For clarity, I believe all of the above to be true. I think I had an excellent surgeon who put me in a position for a healthy recovery. I think I received a very high quality of care from the nurses and other medical staff who watched over me.
But let’s indulge ourselves in some crazy thoughts for a moment. The nurses were incredibly kind. One brought me a heated blanket. Another made me an English muffin with butter and acted like doing so was the highlight of her day. A third held my hand and steadied me when it was time for me to get out of bed. On one hand, they were “just doing their job”. More importantly, they did so with so much grace that at times, I felt a little more like a “guest” and a little less like “surgical patient”. So, I received kind graceful care, but did I receive “good” care, or “excellent” care. I have no idea how closely they monitored my condition when I was under anesthesia, or how carefully they did the pre-op testing. I think I received excellent care, but have no idea what happened when I was unconscious.
The same could be said for my surgeon. He came highly regarded and I’m told he does a high volume of comparable procedures, an excellent proxy for capability in a practice where getting lots of reps matters. When I spoke with him last week, he told me that “the ends came together nicely” meaning the repairs were easy and without complication. That means I’m statistically likely to make a full recovery with fewer side effects. Raji would have asked “how do we know?”. If you really want to go down the rabbit hole of crazy thought, how do I know what actually happened in the operating room. They administered the anesthesia. They told me they repaired all three damaged areas, that the surgery went well, and that I’m in a position to heal well. I have no idea what actually happened once I was unconscious. I only know what they told me.
An important note: This article is about how to find some level of certainty and confidence in uncertain investing situations and I am using a recent personal experience as an example. I believe I had an excellent surgeon who did his job well. I believe I was attended to by capable medical staff who in between ensuring my medical needs were met also went out of their way to make me feel as comfortable as possible under painful and stressful conditions. This section is an example of how to think about uncertainty, not an evaluation of nursing or surgical care.
Given the inability to track and monitor the situation (especially while unconscious), how could I determine I was in a place where I was likely to receive high-quality care? Given that many surgeons develop positive medical reputations due to being likeable while others who are less personally engaging may have better techniques, what could I do to ensure I was in the right place?
I accepted the fact that doing a full background check on everyone wasn’t realistic; however, there are some good (if imperfect) proxies for high-quality medical care. Like finance, good medical people demonstrate an almost-obsessive attention to detail. In the week before my surgery, I received multiple calls from office staff. They went over my instructions in detail covering what I could eat and drink, when I had to arrive, and what I should wear. They covered post-op pain and healing expectations and let me know they’d be confirming that someone would be picking me up from the hospital. Ubering home was not an option. They went through any medications and supplements I might take and did so with patience and incredible attention to detail. I took notes and when I received a summary email from the intake nurse, it matched my own notes.
When I had questions, pre-op staff either had clear answers or told me they’d check and get back to me…then did so. At each step, every issue was discussed, written instructions matched oral ones, and every question received a follow-up answer.
When it came to the surgeon, I applied a similar lens. He patiently collected all the information from me he needed and answered all of my questions directly and without hesitation. He assured me he was a high-volume surgeon, something I had been able to determine earlier through multiple other sources. He talked to me about the kind of equipment he planned to use (Intuitive Surgical’s Da Vinci robot) which I know to be a state-of-the-art choice. Most significantly, the referring doctor told me that if she needed the same procedure as me, this surgeon would be her first choice.
In the absence of knowledge and certainty, we look for the closest proxies possible. I thought a well-regarded surgeon with a trusted referral who provided patient straightforward answers and who used the best available equipment was the best I was going to be able to do under the circumstances. The warm blanket and English muffin were nice, but a detail-oriented medical staff that covered everything carefully even before I set foot in the hospital was an important encouraging sign. Finally, I used a technique that’s effective when doing stock research. In multiple situations, I asked the same question several times. The nurses thought I was just loopy from the anesthesia, but this was intentional on my part. What I’ve found is that reliable people telling the truth tend to stick to the same story while answers tend to shift from those who are less reliable. If I get the same answer 2-3 times in a row, that leaves me feeling more confident.
In this piece, we’ve covered knowing through common sense and a broken public narrative, knowing through research and a different/better understanding of conditions, and situations where direct knowledge is difficult to impossible so we try to identify the best proxies for knowledge and capability. What about you? Have a story where you figured out something where others struggled to gain knowledge?
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