The Theory-driven Stock Investor By Ronnie Ng (www.facebook.

com/bolametrics)
The Theory-driven Stock Investor is an amalgamation of ideas & theories from Warren Buffett & Clayton Christensen.

The phrase past performance is not an indicator of future results, or some variation of it, can be found in the fine print of investment product literature. Yet due to either force of habit or conviction, investors and advisors alike consider past performance to be the most important factor in stock selection. Most investors are people driven by past financial data, and use it to predict the future share price of a business. As number crunching analysts, some of them might argue that using theory to estimate a companys worth is impractical, since it is normally associated with the word theoretical. However, a good theory is practical because a wellresearched theory is a contingent statement of what causes something and why. The law of gravity, for example, actually is a theory. It is extremely useful because it allows us to predict in advance, without having to collect historical data, that if we step off a cliff, we will fall. Good theories allow us to predict the result of an action accurately. Even though most investors do not think of themselves as being theory-driven, they are in reality voracious consumers of theory. When an investor chooses to buy, sell or hold his shares, it is based on some theory or mental model in the back of his mind that leads him to believe that his decision will lead to the desired financial result. The problem is that investors are rarely aware of the theories they are using and often use the wrong theories for their investments. It is the absence of conscious, trustworthy theories of cause and effect that makes success in stock investing seem random. Most stock analysts and advisors are careful not to make assertions that are not backed by past data of a companys stock price. The problem with this approach is that data is only available about the past, and the only convincing data available pertains to the recent past. There is no data for the future, so we have to ask ourselves how we can predict the future. A popular method involves analysts measuring the price fluctuations of a stock against the price fluctuations of the market. This approach represents correlation rather than causality, and it does not help predict the future. For example, the Beta () of a stock is a number describing its volatility in correlation to the volatility of the benchmark that stock is being compared to. Seth Klarman, the author of the book Margin of Safety, says it brilliantly: "I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments. The price level is also ignored, as if IBM selling at 50 dollars per share would not be a lower-risk investment than the same IBM at 100 dollars per share. Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment's volatility compared with that of the market as a whole. This too is inconsistent with the world as we know it. The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk."

Seth Klarman is right to suggest that correlation is never perfect because there are always exceptions. You can use correlation to generalize to a population but not to individuals. For example, even though students in small schools have been observed to have higher scores on standardized tests, not all students' scores would go up if we made schools smaller. There is a correlation between small schools and higher scores, but there is no causality. If we can harness an understanding of causality through the formulation of valid theories, we can better estimate the intrinsic worth of a company. First, Id like to introduce you to Clayton Christensens JTBD Theory.

The Jobs-To-Be-Done (JTBD) Theory

When customers find that they need to get a job done, they hire products or services to do the job. Hence, in order to measure the intrinsic value of a business, we need an understanding that mirrors how the companys customers use its product or service to get a job done. Jobs-to-be-done (JTBD) are what cause people to bring a companys product or service into their lives. Customers buy things because they're trying to get a job done, and we can't understand the companys intrinsic value unless we understand the job those customers are trying to get done. Every customer has many jobs to get done each day from staying awake during a car ride to feeling successful at the end of each day. The stock markets volatility cannot explain why a man takes a date to a movie on one night but orders in pizza to watch a DVD at home the next. Warren Buffett, the worlds greatest investor, probably saw the world this way. Buffett understand the jobs that arise in customers lives for which their products might be hired. Through his investment vehicle, Berkshire Hathaway, Warren Buffett owns the shares of Coca-Cola, Sees Candies, and Gillette. Buffett has famously said these words: Cola has no taste memory. You can drink one of these [Coca Colas] at 9:00, 11:00, 3:00 in the afternoon, 5:00. The one at 5:00 will taste just as good to you as the one you drank earlier in the morning. You cant do that with cream soda, root beer, orange, grape, you name it. All of those things accumulate on you. Most foods do. And beverages. You get sick of them after a while There is no taste memory to Cola. And that means that you get people around the world that are heavy users, that will drink five a day Theyll never do that with other products. So you get this incredible per capita consumption. "When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her. In California the girls slap you when you bring Russell Stover, and kiss you when you bring See's." When I go to bed at night I figure that by the time I wake up 200 million Cokes will have been consumed. Weve got some Gillette [shares] too, and every night I think about two billion plus mens hair growing and four billion womens legs with hair. It goes all night when I sleep. So, how can an investor figure out the customers JTBD by the product or service of a company whose stocks he intends to purchase? The jobs that customers are trying to get done cannot be deciphered from monitoring the daily fluctuations of the companys stock prices. The investor is required to observe, consume, write and think. It entails knowing where to look, what to look for, how to look for it and how to interpret the JTBD.

A large marketing expenditure is a symptom of a company that doesn't understand the job(s) of its product very well. If a product does the job well, people will pull it into their lives naturally such that marketing won't even be necessary. Some other companies that seem to understand this concept of jobs quite well include IKEA, SAS, and Zara. These companies' products themselves might be easy enough to copy, but no one has been able to get the job done in the same way that these companies have. There are three dimensions inherent in every job: functional, social, and emotional. Once a company understands those dimensions of the job, then it becomes important to consider the integrated experiences the company must provide to enable the customer to do the job perfectly. Integrating the customers experience correctly to get the job done means: (1) Whereas products are easy to copy, integration around a JTBD widens the companys economic moats. (2) Customers are happy to pay a profitable price instead of having a zero-sum relationship. When a companys product does a job well, it unlocks a purpose brand value, which is not reflected in its stock price. A purpose brand links customers realization that they need to do a job with a product that was designed to do it. During the early years after a products launch, when volumes are small, word-of-mouth advertising is far more cost effective than media advertising. Positive word-of-mouth advertising only can be achieved after customers have used a product that did the job well. A very long list of powerful brands, including FedEx, Starbucks, and Google were built just this way with minimal advertising at the outset. These brands pop into customers minds when they need to do the jobs that these products and services were optimized to do. A clear purpose brand acts as a two-sided compass. On one side, it guides customers to the right products. The other side guides the companys product designers, marketers and advertisers, giving them a sense of true north as they develop and market new and improved versions of their products. A good purpose brand clarifies which features and functions are relevant to the job and which improvements will prove irrelevant. The brand value in excess to its current stock price is the wage that customers are willing to pay the brand for providing this guidance on both sides of the compass. Thus, when an investor understands who the company is up against in the mind of the customer, he can piece together the real size of the market in which it competes. With that, the investor will be able to estimate more accurately, the intrinsic worth of the company. Quite possibly, the root reason of a bad investment is not that the businesss future is intrinsically unpredictable. Rather, the problem could lie in some of the fundamental paradigms that he follows in understanding how the companys products help its customers get their jobs done.