Influence: The Psychology of Persuasion

As I've previously mentioned, in his speech titled The Psychology of Human Misjudgement, Charlie Munger discusses 25 tendencies that lead to irrational behaviour. He acknowledges that many of these ideas and examples in the speech came from a book called Influence: The Psychology of Persuasion, written by Robert Cialdini. After reading that Munger immediately sent copies of this book to all his children, and gave Cialdini a share of Berkshare Hathaway Class A stock as thanks, I knew that it must be something special.

Indeed, although this is a blog primarily about investing, I was so impressed by the book that I'm persuaded to recommend it here (pun intended). It is not entirely unrelated however, as some of the lessons it contains such as the consistency and scarcity principles are quite applicable to investment decisions, and it is curiously part of the Collins Business Essentials. Originally published in 1984, the 2006 revised edition is updated to reflect new findings about the process of influence, and at the end of each chapter, Cialdini discloses letters that readers have written to him about their personal experiences. 

Like many people, Cialdini admits that 'All my life I've been a patsy', so as an experimental social psychologist, he spent 35 years conducting experiments into how people think and what makes them likely to be persuaded. In addition, he spent three years going undercover by applying for jobs in fields such as real estate, user car dealerships, advertising, public-relations, fund-raising, telemarketing and restaurants. These insights into how the professionals get us to say 'yes' provide a nice demonstration that what works in experiments applies equally well to the real world. Cialdini's writing style is easily understandable and humorous, but fortunately doesn't patronise readers by oversimplifying. My only criticism is that he tends to be a little repetitive in drilling home the results of an example or the message he's trying to convey, but overall the book is a pleasure to go through. 

Influence: The Psychology of Persuasion details six very powerful principles, one per chapter:

1. Reciprocation

2. Commitment and Consistency

3. Social Proof

4. Liking

5. Authority

6. Scarcity

These principles usually work to our great benefit, but our regular reliance on them may cause lapses in judgement, especially when someone is intentionally exploiting them. Although some may seem obvious, I think you'll be surprised how powerful they are once you read example after example of their applications. By understanding how these principles work, you can use them yourself to help persuade others (hopefully with good intentions), or you can avoid being led into unwanted situations (Cialdini explains 'How to say no' at the end of each chapter). Interestingly enough, even though I'm planning on pursuing a major in psychology - as well as finance and accounting - my first few weeks of social psychology have made no mention of any of these principles. 

Using these principles, Cialdini explains why a woman in New York was chased and stabbed to death while 38 of her neighbours watched on without calling the police or intervening, why the number of airplane crashes and automobile fatalities shoots up after a highly publicised suicide story, and how a cult leader got more than 900 people to kill themselves in an orderly fashion by passing around a vat of poison. To find out the tragic and disturbing reasons for these extreme examples, you'll have to read the book! 

In summary, if this was a broker report, my recommendation would be BUY. 

Finally Sold Delta SBD

Delta SBD, an underground coal mining services business I bought shares in almost a year ago, has been by far my worst investment mistake of commission. Just as my cat learned very quickly not to pee on the carpet after my dad rubbed his nose in it, I believe that rubbing my nose in my mistakes is a good practice. Thus, today's rather unpleasant post.

Less than six months ago I mentioned the discomfort that this stock had given me in the context of psychological biases, but justified my decision to hold onto DSB as I thought it was still cheap. Well, it now seems that Mr Market (an allegory for the general share market) was right in his pessimistic appraisal of this business, and after the most recent half yearly results of DSB came out on Friday, I have come to agree with him. In fact, it took me all of around five minutes of reading the report before I knew that my valuation was wrong and that I should get out quick. 

I sold out in two parcels, one at $0.29 and another at $0.28, before the share price dropped further to close at $0.25 - an almost 22% drop in one day. After accounting for fully franked dividends and brokerage costs, my personal losses have been 61% and 44% for the two respective parcels, or a total of $845 in dollar terms. These are unpleasant numbers, but if it's any consolation to myself, they're not as bad as Delta SBD's results.

Revenue for the half fell 52% to $35.4 million, while the underlying profit of $5.2 million became an underlying loss of $1.0 million. All $29.2 million of DSB's goodwill was written off, and a couple of other minor items meant that the statutory loss totalled $30.7 million. Poor results were widely anticipated due to the severe downturn in the Australian coal sector, but evidently they were worse than what I, and the market had expected. The announcement was enough to send DSB's closest listed peer, Mastermyne Group (ASX:MYE) down almost 15%, even though Mastermyne's share price had already been punished from its similarly disappointing half yearly report three days earlier. 

Although the market capitalisation of DSB is $11.6 million and it has net tangible assets of $28.2 million, the bulk of its assets are in the form of plant and equipment, which in the current industry climate would almost certainly be worth less than the $37.6 million stated on the balance sheet (this amount reflects historical cost minus depreciation rather than what you could sell it for on market). Indeed, DSB sold some of its assets to provide cash, and recorded a loss as part of its statutory results from it. Therefore, it doesn't appear to me that there is sufficient protection if DSB were to go into administration, and although I am not predicting this will eventuate, there are some eerie similarities to the rapid demise of Forge Group that make me uneasy. 

For one, cashflow from operating activities has deteriorated dramatically, going from inflows of $2.9 million, to an outflow of $1.9 million in the current half, and as previously mentioned, the business has moved from an underlying profit to an underlying loss. Once you get into the world of negative compounding, it can be very difficult to dig yourself back out, and it seems to me that DSB won't be able to withstand the pain for much longer. This business has a worryingly high net debt to equity ratio of 51%, and a current ratio of just below 1.0, indicating that it will be having some funding issues over the next few months. To their credit, management have been working at reducing debt levels as fast as they can, but with the company now bleeding cash, it seems the only avenue for further deleveraging will be more asset sales. 

Buried in the 'going concern' section in the notes to the financial statements, there are some more worrying signs about cashflow and debt. The directors acknowledge the need for an additional working capital financing facility, which they expect they will have to start drawing down on in March 2014. DSB has been working to secure an invoice finance facility of $4.65 million from an external financier, but should this fail, the group's major shareholders - who I presume are the two founders of the business that own a collective 47% - have committed to provide a facility of $3.5 million. However, there are also strings attached to this shareholder funding, and the report ominously warns that it "will be conditional on achieving predicted revenues levels and appropriately managing the volume and profitability of the business. Should this not be achieved and the Group is unable to restructure existing equipment finance arrangements or raise additional capital, the Group may not be able to continue as a going concern." Further paralleling the signs of desperation that Forge Group displayed before it collapsed, management revealed that "the Group continues to negotiate with finance providers to extend the repayment terms of other existing equipment finance arrangements, and is considering a capital raising via the issue of new shares." 

And finally, whilst I rarely place much emphasis on macroeconomic forecasts (although I probably should have in the case of DSB), the environment for an underground coal mining services business seems pretty bleak to me. The big miners - BHP Billiton and Rio Tinto - have cut capital expenditure in their coal businesses, and in the face of lower prices, capex spend is set to fall further. I'm no expert, but with the rapid increases in the efficiency of solar power that I've been told are trending even faster than Moore's Law in computing power, and the rise of other renewable energy such as wind power, I can't see a bright long-term future for thermal coal. In addition, China, which is the world's biggest consumer of thermal coal, has been making moves to clean up its pollution by reducing its dependancy on thermal coal. As for metallurgical coal, prices are to a large extent dependant on China continuing to grow at a fast rate and build tons of infrastructure, an assumption that appears far from a sure thing to me. 

After all the above, you may be wondering why on earth I ever held shares in this business and why I didn't sell out sooner. I am too. But I think I can list a couple of factors that contributed to this result, many of them psychological. In response to the first question, I repeat what I said six months ago: "I knew going in that this was a fairly mediocre business (current normalised return on equity of 14%, net debt to equity of 32%, and a net profit margin of 5.5%), and anticipated a less than impressive earnings outlook, but the price looked cheap enough to offer a significant margin of safety - less than 5 times FY2013 earnings. In addition, I liked that the founders of SBD and Delta were still managing the company, and held a majority stake." I figured that if DSB could withstand a short term downturn in the coal sector, I would make a fair bit of money. However, in light of the recent results that's a much bigger 'if' than it was almost a year ago when I first purchased shares. 

Last time I also listed confirmation bias as one factor that hindered a true objective analysis of the situation - I remember reading analyst reports that had big 'BUY' recommendations on them, and although my estimates were more conservative than theirs, we were both way off the mark. After recently reading Charlie Munger's brilliant speech, The Psychology of Human Misjudgement, I realise that I most certainly fell victim to what he calls Inconsistency-Avoidance Tendency (the brain naturally being resistant to change in ideas, once you make your thoughts known in public, as I did on this blog, the tendency becomes even stronger), and Overoptimism Tendency (fairly self explanatory). Eventually I recognised that the risks of my investment in DSB had gone up significantly, and deliberated many times on whether to sell out, but never did something about it, until of course this report came out, when my fears were confirmed. 

Another one would be Contrast-Misreaction Tendency, which is perhaps best explained through the boiling frog anecdote. Although the scientific background is shaky, the story goes that if you place a frog in boiling water, it immediately jumps out, but if you place it in cold water and slowly turn up the heat, it will boil to death. Thankfully, the consequences for me were not so serious, but this cognitive bias applies to the brain and the message is the same. I should have reacted to the little pieces of information that built up over time indicating this was a bad decision. Instead, it took a real splash of boiling water in the form of this half yearly report for me to jump out. 

There was simply not enough of the 'invert, always invert' that Munger espouses. Unfortunately, once I have sold out, inverting becomes so much easier to do, as the above paragraphs demonstrate. I should have listened more to the wisdom of Peter Lynch who said, "Rather than being constantly on the defensive, buying stocks and then thinking of new excuses for holding on to them if they weren't doing well (a great deal of energy on Wall Street is still devoted to the art of concocting excuses), I tried to stay on the offensive, searching for better opportunities in companies that were more undervalued than the ones I'd chosen." If someone had asked me a month ago if I would invest in DSB, my answer would definitely be 'no' because the risks were too high, so why did I hold shares in it? Because I made kept making excuses. 

Perhaps I should have also followed the advice of Buffett and Munger, in avoiding the 'cigar butt' style of investing that they had success with but eventually moved on from. But unlike Mark Twain's cat that sat on a hot stove and never sits on another stove, hot or cold, I haven't been burned severely enough by this cigar enough to dismiss cigar butt investing on my first attempt (my apologies for all this burning animal imagery).

Last time I concluded my discussion on DSB and investor psychology by saying, "The verdict is still out on what the future of DSB, the coal sector and China is, but regardless of the outcome, I hope that I will have at least taken away some valuable lessons about investor psychology that will improve my decision making going forward." I just wish it wasn't such an expensive lesson.

P.S. Not all is bad though, Warren Buffett's annual letter to Berkshire Hathaway shareholders was published over the weekend, and as has come to be expected, it is always a good read. To any value investor, his annual letters are required reading.