Wednesday, October 13, 2010

A Microsoft Story

In my earlier investing days I tended to make investing decisions based on short compelling stories about stocks. Some of these stories I got from others and some I created myself. These thoughts still rattle around in my head, but I no longer act on them. Consider the following story about Microsoft:

Computer speeds are not growing the way they once did. It used to be that we could count on the speed of computers to double every year or two, but no more. A result of this fact is that consumers have less pressure to replace their computers as quickly as they once did. Microsoft makes money by selling a new copy of their operating system with new computers. Fewer sales of new computers will reduce Microsoft’s sales. In addition, dropping computer prices reduces the price Microsoft can change for their operating systems. The end result is a bleak future for Microsoft stock.

Let me begin by saying that I don’t know whether the premise of this story is correct. Even if the premise is correct, the conclusion may be wrong for other reasons. One could certainly concoct many other stories related to Microsoft stock that focus on their business in different ways. Some of these stories would be bullish and other bearish.

My real point is to illustrate the kind of reasoning that used to drive my investing behaviour. From listening to others who invest in individual stocks, I find that their reasoning for liking or not liking given stocks tends to boil down to a short story like the one above. I used to check a company's financials as well, but in the end my investing choices were usually driven by these short stories.

I’d be interested in finding out whether my story above actually affects anyone’s thinking about Microsoft stock. However, I have undermined the study by admitting that I don’t believe it myself. (I don’t believe it is wrong, either. I just don’t know.) I’ve also undermined my story’s impact by calling it a story rather than a “stock analysis”. I also failed to include a bunch of pointless charts of recent stock performance that might lend greater credibility to the story.

If I have any talent at creating such stories maybe I have a future as a stock “analyst”. It’s more important to sound compelling than it is to have a record of correct predictions.

10 comments:

  1. The flaw in the argument is this line: Microsoft makes money by selling a new copy of their operating system with new computers

    That implies a 1:1 ratio of operating system to computer. Because processing speeds are no longer doubling, the same computer can have successive versions of operating systems installed, and in fact MS has in some respects a captive audience of consumers, especially if it's reinforced with an office editing suite, etc.

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  2. @Geoff: I agree that if people keep their computers longer more of them will buy a new OS for the same machine. However, I think this effect will be small. For the most part, people don't buy a new OS for an old machine; they tend to get a new OS when they buy a new machine. Your observation softens my conclusion, but only slightly, in my opinion.

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  3. You could improve the story by adding some valuation analysis, but you're right that a lot of analysts don't even touch upon this.

    Lately I've heard a lot of "Gold is going to go up because..." without any discussion regarding its current price relative to that of two or three years ago. Perhaps the price of gold has already adjusted to these future conditions, but the analysts are not focused on the value proposition, only the story.

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  4. @Gene: I agree that valuation analysis would make sense, but my goal was to write something that seems compelling without having much substance. That said, even if I added some valuation analysis, the result would be mostly useless for investing because I don't have any real idea of what will happen to Microsoft's stock.

    On the subject of gold, I have a hard time with any kind of valuation analysis because the inherent value of gold is very low compared to its price. Gold doesn't create new value the way a business can. Gold just sits there and costs the owner money to guard it.

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  5. Somewhat related to what Gene was saying: your story line indicates what the stock may be worth, but it ignores what the stock costs, and you can't tell whether a share is worth its price without estimating both.

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  6. @Patrick: I agree that I can't tell whether a stock is worth its price without attempting to value the stock. My point is that even after estimating the value of a stock, I still can't tell whether the current price is worth it because I don't trust my valuation. The evidence says that the vast majority of investors who do trust their valuations are simply overconfident.

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  7. Michael, you've made a point that many investors miss. People make their decisions based on emotion (like your story), then backfill the reasoning (charts, valuations, etc.). The research I've seen suggests that stock analysts are very good at telling which company, of a group, is the strongest and which is the weakest. Analysts are very bad at predicting prices in a year.

    The story is great and it describes why or why not I'm comfortable owning a stock. But whether or not it's a good investment depends on unknowns and uncontrollable events so much that it's impossible to predict the future. And I think that's what you were trying to say.

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  8. @Robert: Well said. The curious thing is when I say something similar to what you wrote, I find that some people nod their heads in agreement and then go on to discuss whether some stock is a good investment or not.

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  9. Stories are good as long as we ponder deeply on them. Charting an economy area could be easier than another one. The fact that China is adding more nuclear plants to it's inventory is a clear indication that the pressure on uranium mining will increase and prices will go up. It's nuclear plants and there is no discussion about what they need to run. Betting though on the scientific progress of humanity - how quickly processing power will develop, what new ways we'll find to do that, is a completely different game. I have been hearing for about 12 years that we are nearing the limitations of silicon for building bigger and better processing chips, and yet now and then they manage to break through that. Who could have made a safe bet on IP vs ATM in 1999?! And examples can continue...

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  10. @Andi: Even your story of Chinese nuclear plants has a stumbling point. By the time I find out that China is building more nuclear plants, others have heard the same thing and uranium prices already will have risen. So, uranium prices may not rise after I figure out that they should rise.

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