Skills That Separate You as an Investment Manager: Scaling
Previous editions of this series on Skills That Separate You as an Investment Manager have focused on introspection, creativity, intuition, decisiveness, absolute vs. relative decision making, forthrightness, and discernment. This month’s edition is about a powerful skill I initially discussed at length in my book The Intuitive Investor that literally changes how you see the entire information landscape: scaling.
The use of proper scale is a tremendously overlooked secret to investing success. Let me illustrate the importance of scale with a thought exercise: What is the proper scale for watching a football match? Most answer: “As close as is possible.” But what if your eyeballs are right on top of the ball itself? You miss most of the action, despite being at the absolute heart of the game. Clearly, you are too close for anything to be meaningful. Say instead that you are seated in outer space hovering around the earth. Would that be a great seat for seeing the action? Probably not. You are way too far up from the action for anything on the pitch to be meaningful to you.
So what’s the ideal scale to see a potential investment? Your preference for scale should be the scale, or scales, that provide you with unique and actionable investment information. A natural starting point for examining scale is to ask: “What is the fundamental value driver of a business?” It might be the amount of research and development dollars spent, revenue per (railroad) track mile, number of website page views, quality of service, quality of products, or the customer experience.
In the world of investing, common-size statements are an example of changing scales to reveal new information. Two primary forms predominate: common-size over revenues and over total assets. Why can’t you do common-size statements over headcount? Or common-size over total operating cash flow? Or barrels of oil? Or square footage of property owned? Or research and development dollars spent? Another example from investing are the many financial ratios, such as the cash conversion cycle (CCC) and the DuPont equation, that change how businesses are viewed.
One of my investment secrets is that I identify the fundamental operating units of a business beyond dollars and then rescale information for greater clarity. There are numerous examples of industries that think in terms of units other than dollars, such as in the oil business where barrels of oil are the fundamental unit. So, if you know an oil company produces $100 million in profit in a quarter and you know that they also produce 5 million barrels of oil, it’s useful to calculate the profit per barrel of oil (the scale). You can then compare that figure to the company’s competitors. This is a change of the scale from dollars to barrels of oil.
In the airline industry they quote a number called “revenue per passenger mile,” where miles are the fundamental unit. In the hotel business they quote the “occupancy rate,” where how many hotel rooms are filled each night is the fundamental unit. In a business that is people driven — consulting, for example — numerical data scaled to employee headcount is often revealing, such as sales per employee. These are all examples of changing the scale and they are designed to illuminate the fundamental qualities of a business.
Unfortunately, most analysts have an unstated scale prejudice, and hence a blind filter — “my investment time horizon is five years” or “I prefer companies whose earnings growth is accelerating” — that obscures as much as it reveals. This happens because many investors have lost sight of the fact that the job of an analyst is simply to see and to accept the world for what it is, not for what we prefer it to be.
Can you see how adjusting the scale changes your perception and, therefore, your understanding of things? This is a critical skill to add to your repertoire. Anything that can be measured can have its scale changed to help illuminate valuable information. Finding the proper scale helps to turn data into information. Importantly, scale changing is also a creative, right brain-oriented endeavor limited only by your imagination.
Arguably, the scale most overlooked is time. Changing the time scale drastically alters understanding. In fact, it is my belief that most disagreements about investing are the result of unstated time preferences. Getting the time scale right when you analyze a business is critically important. Do you evaluate future prospects over 10 seconds, 10 minutes, 10 hours, 10 days, 10 months, or 10 years? It does change the answer of whether to buy or not buy.
For example, a primary difference between so-called value investors and so-called growth investors is a differing appreciation for time. Growth investors typically have a shorter time horizon (i.e., scale) than value investors. After all, growth investors are looking for companies’ earnings to increase 100% year over year, not over the course of 60 years.
Alter your scales many times to maximize your insight when evaluating investments. Very frequently new information is revealed by changing the scale. Think of this process as learning to know when to utilize your eyes only, a microscope, a pair of binoculars, or a telescope when looking at information. Sometimes you want a scanning electron microscope when examining an investment issue — such as understanding the full legal consequences of a regulator’s enforcement action — and at other times you want to use one of the huge-mirrored telescopes of an astronomical observatory when trying to understand something — such as the effect of changes in global demography on global GDP.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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