As well as helping to understand, I believe that these models reduce certain cognitive biases. In other words, mental models can help us avoid psychological errors.
To illustrate this point, this time I will use a concept related to the field of philosophy. This example is inspired by a passage from Robert Hagstrom’s book, Investing: The Last Liberal Art, a very interesting book that deals with mental models.
What do you see?
In the book Philosophical Investigation published in 1953, philosopher Ludwig Wittgenstein discusses the importance of the words used. Look at the image below. What do you see?
Some would say it is a triangle. Others will say it is a mountain, an arrowhead or even a hole. Even if the image does not change, your perception of the image changes based on the words used.
In other words, the description you make gives meaning to what you see and understand.
Amazon vs. Barnes & Noble
This philosophical concept is very important in investing. How you describe a company will have a big impact on how you value it. In his book, Robert Hagstrom gives the example of Amazon in 2002.
At that time, Amazon had just experienced the bursting of the technology bubble and its stock had lost no less than 78% of its value. Despite this drop, several pessimistic investors (“bears”) believed that the stock was still overvalued. Their main argument was that it was nothing more than a retail company and did not deserve such a high rating. They compared Amazon to Barnes & Noble and Walmart.
Conversely, optimistic investors (“bulls”) saw a business model that resembled computer maker Dell more than Barnes & Noble bookstores. Like Dell, Amazon operated its business online, shipped its products directly to consumers through fulfillment centres, and used no physical location or sales force.
Even though Barnes & Noble and Amazon were in the same business, selling products such as books, their business model was very different. One could not be compared with the other.
The failure to adequately describe Amazon’s business model misled the pessimists. Of course, valuation is very important and should always be considered before making a purchase. Nevertheless, the investor should be sure to keep an open mind when describing a company’s business model. Investors should constantly question their description in order to avoid tunnel vision.
Tesla
This description bias reminds me of the Tesla situation. Over the past few years, I have heard plenty of talk from investors who describe Tesla as a technology company while others describe it as a traditional automaker. Obviously, the growth and profitability prospects of these two business models are very different. The parameters to be used in the evaluation process are therefore also different.
As an investor and portfolio manager, it’s my job to constantly question my description of a company. I don’t have to change my mind, but I have to perform this exercise constantly. As we saw above, my description of Tesla will inevitably affect my perception and therefore my assessment.
Look again at the figure above. Is it a triangle or a hole?
Jean-Philippe Legault, CFA
Financial analyst
