The Toolkit Approach
The core idea of The Equity Toolkit is that to develop a framework for understanding the investment system requires a large set of tools. This idea is not original and follows the mental models approach of Charlie Munger¹:
“Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ‘em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form.
You’ve got to have models in your head. And you’ve got to array your experience both vicarious and direct on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.
What are the models? Well, the first rule is that you’ve got to have multiple models because if you just have one or two that you’re using, the nature of human psychology is such that you’ll torture reality so that it fits your models, or at least you’ll think it does…
It’s like the old saying, “To the man with only a hammer, every problem looks like a nail.” … So you’ve got to have multiple models.
And the models have to come from multiple disciplines because all the wisdom of the world is not to be found in one little academic department. …
You may say, “My God, this is already getting way too tough.” But, fortunately, it isn’t that tough because 80 or 90 important models will carry about 90% of the freight in making you a worldly wise person. And, of those, only a mere handful really carry very heavy freight”
The idea of having a broad toolkit of approaches also has empirical support. Phillip Tetlock² spent decades studying the accuracy of political forecasters and classified his subjects as either hedgehogs or foxes:
“the intellectually aggressive hedgehogs knew one big thing and sought, under the banner of parsimony, to expand the explanatory power of that big thing to ‘cover’ new cases”
“the more eclectic foxes knew many little things and were content to improvise ad hoc solutions to keep pace with a rapidly changing world.”
In measuring the forecasting performance of these group’s, he found that foxes dominated hedgehogs, although even the best foxes struggled to outperform statistical models.
There is also good logical support for the need to have different thinking tools. Edward De Bono notes³:
“The rear left wheel of a … car is excellent. It cannot be faulted or attacked on any grounds. But that wheel by itself is not enough. If you believed that all you needed on a car was one wheel, there would be something wrong with your thinking – not with that rear left wheel. We also need the other wheels. The rear left wheel is excellent – but it is not enough”
… and therefore we need to adopt different models and frameworks,
“I want to make it clear that argument is an excellent method when used in the right place. But it is not enough. We need a different method and framework (software) for exploring a subject in a constructive way.”
The advantages for an Equity Analyst of having many mental models and a broad selection of tools are numerous:
- The tools and models will help to develop a framework of understanding, not just a collection of knowledge.
- The opportunity to choose the right tool for the right job. The nature of the investment system means we need to have tools for analysing different parts within the system, different relationships between these parts and different behaviours of the system. This may be particularly important where we lack the information required to use a particular tool. For example, we may have financial history but limited operational understanding (or vice-versa).
- The ability to compare the answers provided by different tools. If all the tools provide the same answer (i.e. it looks, quacks and smells like a duck), then we can have increased confidence in the outcome. In contrast, if different tools provide different outcomes (e..g cheap on PER, expensive on P/Book), not only is our confidence reduced, but the need to choose between two alternatives will likely improve our understanding.
- It can force us to consider different options, therefore avoiding the bias that Daniel Kahneman describes as WYSIATI syndrome – What You See Is All There Is4;.
To gain the full benefits of the toolkit, the analyst must have access to a large and diverse set of tools. In addition, the analyst must know how and more importantly, when, to use each tool. The Equity Toolkit is about helping improve these outcomes.
The Equity Toolkit is organised around eight group’s of Tools that we call Frames, each of which represents a broad method of analysis. The Analysis Frames are a wide range of traditional analytical tools and models for understanding the different sub-systems of the Investment system. The Application Frames are more generic tools and models for both gaining either a better understanding of how to use the tools, particularly in a holistic systems view, and for understanding when to use each tool.