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An excerpt from the new book 'Active Value Investing' by Vitaliy Katsenelson, reprinted with permission of the author and publisher:

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You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. — Benjamin Graham

Be A Myth Buster

My son Jonah’s favorite TV show is Myth Busters. On this show, special effects experts use their skills to test the validity of urban legends—myths. Using modern-day science they separate truth from fiction. Instead of just explaining how something is scientifically possible, they test it. The show might test, for example, if running in the rain instead of walking would keep you drier. That myth was confirmed to be true, but another well-worn myth—‘‘a shotgun barrel plugged by a human finger will backfire and explode, injuring or killing the shooter instead of the intended victim’’—that myth was busted.

Just as the perfect retirement home in sunny Florida cannot exist without a bingo night, Wall Street cannot survive without myths. The dictionary defines myth as a widely held but mistaken belief. The key words are widely (impacting the stock price) and mistaken (creating an opportunity). If just mentioning a stock name elicits a widely accepted/off-the-cuff reason for why the stock should not be owned, you may have a myth on your hands.

A myth may start its life from a company’s press release, a news story, or an analyst comment. Just because an opinion is widely accepted doesn’t mean that it is de facto a myth, but you already have half of the required ingredients for it to be one. The second half, of course, is that it be wrong. To bust a myth you need to prove that a widely accepted opinion is wrong. Also, to make sure you bust the right myth, it has to be properly defined. The following line is an example of a properly defined myth statement:

XYZ stock is not a good buy, because ABC will enter the industry and will drive it out of business.

Properly phrasing the myth is crucial to being able to test it. Otherwise, you may miss an attractive buying opportunity. Make sure you are testing the myth in relation to a company’s stock, not the company itself, as a much worse scenario might already be priced into the stock. For instance, perhaps your myth-busting phrase is ‘‘Wal-Mart is not a good buy because it grew too big; slower growth looms.’’ Well, this may not be a myth, as Wal-Mart’s sales growth will probably slow down from historically achieved levels.

However, if you phrase a myth correctly (about a stock), the phrase becomes ‘‘Wal-Mart stock is not a good buy because its sales growth will slow down’’; you may find, for instance, that although Wal-Mart’s great size will slow down its sales growth from 15 percent to 9 percent, the market is already pricing in only 5 percent growth, making Wal-Mart stock a great buy.

The Myth Busters program busts myths by testing everything, not taking anything for granted, and you should do the same. They often do it by conducting experiments that may result in bodily injury if not done right, but don’t worry, you won’t be asked to do the same. Whenever you detect a myth surrounding a particular stock, phrase the myth correctly and then quantify! Build vaguely right models, test different what-if scenarios, and be prepared to buy or sell based on the inconsistencies between consensus and revealed truths—the myth and what the numbers say. Once armed with facts and research, you are less likely to be swayed by the pressure of crowd thinking. Quantifying will help you to manage your own emotional impulses and will give you an edge against the crowd. Discounted cash flow model is a great quantifying contrarian tool, as it provides good intelligence on the expectations built into the stock.

But often analysis doesn’t have to be that complicated. Sometimes the real story is just beneath the surface. In September 2006 Wal-Mart announced that it would start selling 300 generic drugs for $4 each in its stores in the United States. This news sent stocks of stand-alone pharmacies Walgreens and CVS crashing down as much as 10 percent on the day of announcement, further declining in the next two months by another 10 to 15 percent. The myth headlines sounded like Wal-Mart, a company responsible for driving many retailers out of business, was about to have stand-alone pharmacies for lunch.

The properly phrased myth to be tested was: ‘‘Walgreens and CVS are not good stocks because Wal-Mart’s $4 generics will substantially impact their profitability.’’

However, once you quantified the myth, you’d realize that the Wal-Mart program had the biggest impact on consumers who were paying for prescriptions out of their own pockets, which accounted for a small portion of CVS’s and Walgreens’ sales. In fact, only 5.9 percent and 7.1 percent (per 2005 annual reports) of CVS’s and Walgreens’ pharmacy sales were paid by consumers directly; the bulk was paid by third parties (insurance companies, government, and states). Out of this 5.9 percent and 7.1 percent, only a portion went to branded drugs and the rest went to vitamins and generics.

Therefore, the impact of Wal-Mart’s $4 generics program on Walgreens’ and CVS’s future sales was likely to be negligible. That myth was busted!

Source: Be a Myth Buster ('Active Value Investing' Book Excerpt)