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The Globe and Mail

Dumb questions, heroic assumptions and the available evidence

A few weeks ago, The Globe and Mail ran an article where a management coach cautioned top managers and directors against helping too quickly those who report to them, and to avoid providing ready-made answers to problems. Instead, directors and CEOs should ask probing questions to develop their managers' ability to come up with better answers on their own. There was even a sampling of such probing questions.

That article struck a chord, because as a past research director on Bay Street (three times), I often had to bite my tongue and transform my answer into a question aiming to do just that.

So, in the spirit of helping you improve your own investing, here are three research director's probes: A dumb question, a question about heroic assumptions and a question about the evidence.

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Let's take the dumb question first.

Say an analyst recommends an established, senior gold producer. I'd send him immediately to do a chart of the company's long-term stock price (including dividends), divided by the price of gold. (Or, if he recommended a senior copper producer, divided by the price of copper.)

Why? Because when you buy a senior gold (or copper) producer, you get the metal exposure, which is what you want, but you also get balance sheet risk, management risk, and (often) country risk. Now look at the price ratio chart. If it's flattish to down, it means that, over the long term, this gold stock did not even outperform the metal. So why should I (or a fund) want to own it? I can just own gold bullion, or gold ETFs, or gold futures and roll them every three months (which is cheapest).

But, you may say, a pension fund cannot own gold directly, and certainly not futures. My answer: This was the past. Today many can, and even those who cannot can own a gold ETF that moves like gold. So a senior gold (or copper) stock must first outperform the metal or you'd buy the metal directly - same as your money manager must outperform the market or you'd buy an index fund.

Now a double sidebar regarding junior mines:

First: Whereas large, senior gold mines often merely replace the ore body they dig out, in junior mines you have a chance for a payoff if they find an ore body not yet reflected in their stock. So here you bet not just on the metal, but also on management - and luck.

Second (and there's another dumb question or two here): Say you're pitched a junior gold stock in, say, the South American country of Fredonia, whose ore body is worth, say, $10 per share. The shares trade at $5. Should you buy? Well, the immediate dumb question is: What discount rate did the analyst use to compute the present value? Five per cent over 10 years, he says? Well, what do Fredonia's 10-year government bonds yield? Eight per cent? Then why don't we just buy those ...?

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The second research director's question has to do with heroic assumptions.

Say an analyst recommends a "buy" on a low-growth stock. He's sure that earnings will be so wonderful that they will surprise everyone and the stock will zoom higher.

The first question I'd ask is: Are you forecasting better-than-ever earnings because you forecast higher-than-ever gross margins? If so, you may still be right, but you'd be making a lower-probability bet. I'd much rather look at a "buy" based on a gross margin forecast below the historical peaks - your chances of being right are higher that way, all other things being equal.

Ditto if the analyst forecasts that a company whose sales growth averaged 5 per cent a year over the past 10 years will suddenly increase 15 per cent. Yes, he may still be right, but he would have to work harder to convince me, since that, too, is a heroic assumption.

Ditto for a cyclical stock trading at $14 a share that over the past twelve years has always fluctuated between $7 and $15. Here, although revenue, book value and share count are the same as five and 10 years ago, the analyst forecasts a price of $22. Sure, he may be right - the company may have changed - but he'd have to work hard to convince me.

The third kind of probing question simply looks at the evidence.

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Assume an analyst says: This senior company is about to post a large loss - it has lost so much only three times before: In 1974, 1982 and 1991. So I recommend a "sell." My immediate question is: Look at the price chart. Were these big-loss years good times to sell? They seemingly were "buys." Of course, you may still be right to sell today, but the evidence shows your chances of being right are low. Do you want then to rethink it?

If you practice asking yourself such questions before you invest, you're bound to do better. Because in investments, as in poker, it's better to take only high-probability bets and avoid the low ones. (Unfortunately, and unlike poker, in investments you can't win by bluffing.)

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