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Seeking Disconfirming Evidence

Last month I wrote an article regarding disconfirming evidence and feedback mechanism. That article covered how to develop a proper hypothesis and feedback mechanism, but it did not go into deeper detail on how to seek disconfirming evidence. In this article, I'll share some of my best practices of seeking disconfirming evidence for a developed hypothesis.


Short reports

If you are long a stock, one of the most important reports you can read are reports by short sellers of the company. They will lay out most, if not all of the negative arguments against the company, and all you have to do is to either find a way to invalidate their evidence or accept their arguments as superior and change your mind.

A great example of this is Herbalife (NYSE:HLF). When Bill Ackman (Trades, Portfolio) laid out his voluminous bear case against the company, after spending heavily on due diligence, he has done a great job enlisting all the possible things that could go wrong with the company.

One investor found multiple inconsistencies in Ackman's presentation. For instance, Ackman claims that distributors who bought billions of Herbalife's products were not making money because they would not be able to sell those products. However, this investor found out that the distributors can actually buy the products from Herbalife for half of the suggested retail price and sell them on Ebay for 60 percent of the suggested retail price. This means Herbalife's distributors actually make money from selling the products. Using Ackman's own evidences, this investor invalidated Ackman's bear case.

Another example is New Oriental Education & Technology (NYSE:EDU). A couple of years ago, the stock tanked due to a short seller report claiming the company was making fraudulent financial statements. However, if you read the short seller report, this claim was based on insufficient evidence, and given the integrity of the management team, it would be very easy to dismiss the short seller's false claim.

Disagreeing investors

Speaking to investors who are knowledgeable about the company and have the opposite view, or a less optimistic view than you, is also a great way to gather disconfirming evidence. This is especially important if the optimism comes from management's guidance.

The best example I can think of is a case regarding a company called PHI Corp (PHIKQ). This is a company helicopter operator with two principal segments: Air Medical (AM) and oil and gas. It was a highly leveraged company, but the air medical business is cash flow positive, and it has some valuable assets. It was trading cheap, a top pick of a renowned microcap investor dubbed "The Warren Buffett of Microcap Stocks."

The bulls laid out all the optimistic scenarios for the company but the bears basically invalidated all of them with sound logic and reason. It's a wonderful case of Charlie Munger (Trades, Portfolio)'s analysis of human psychological misjudgments. The bulls dismissed all important disconfirming evidence using emotional and arrogant language. Even after the company has filed for bankruptcy, they still hoped for a Hail Mary play.

Keeping track of your own disconfirming evidence:

Let's say there are no short reports available and we can't find any educated investor with the opposing view. What can we do then? That leaves us with only one option - invalidating our own hypothesis, which is incredibly difficult. As I wrote before, the important thing is, we have to have a non-vague verifiable hypothesis so we can develop a system to monitor whether we are right or wrong. In other words, we need to figure out what would happen if our hypothesis is correct and what would happen if our hypothesis is wrong. For instance, one of the competitive advantages of Wells Fargo (NYSE:WFC) is the low cost of deposits. The company discloses the information on a regular basis. You can compare it to its competitors and see whether the gap is widening or narrowing.

Conclusion

When Charles Darwin found something that was contrary to his established conclusions, he quick wrote it down because our minds tend to dismissive disconfirming evidence. As investors, we should follow Darwin's practice. The aforementioned methods are by no means comprehensive, but they are practical. Only by actively seeking disconfirming evidence can we become more rational.

Read more here:

  • Luckin Coffee - The Starbucks of China?
  • Margin of Safety, Circle of Competence and Intellectual Honesty
  • Distorted Incentives: Why Less Is More



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This article first appeared on GuruFocus.