Practical stock researchModule 3, lesson 13 of 23
Comparing competing explanations
How to generate alternative explanations for a company's results, find evidence that tells them apart, and avoid settling on the first story that fits.
In this lesson
- Generate several plausible explanations for a trend in a company's results.
- Identify evidence that would distinguish between the explanations.
- Weigh explanations using peers, base rates and the company's own disclosures.
- Explain why a story that fits the numbers is not necessarily the right one.
Builds on
- Building scenarios from assumptionsDifferent explanations lead to different scenarios.
- Correlation and causationCompeting explanations are a practical application of separating correlation from causation.
On this page
In simple terms
When a company's margins rise, sales jump or debt falls, our minds quickly produce an explanation. Often it is the one that fits what we already believe about the company. But most trends have several possible causes, and they have very different implications for the future.
Good analysts deliberately list alternatives, then look for evidence that tells them apart.
Generate alternatives
Take a trend and list at least three explanations, including uncomfortable ones.
Worked example: Why did a made-up company's margin rise from 14% to 18%?
| Explanation | What it would mean |
|---|---|
| 1. Pricing power from a stronger brand | Lasting improvement |
| 2. Lower raw material prices | Temporary; may reverse |
| 3. Cuts in advertising and maintenance | Profits borrowed from the future |
| 4. Costs capitalised instead of expensed | Accounting change, not better business |
| 5. Mix shift to higher-margin products | Lasting if the mix holds |
Each explanation implies a different future, and a different value in your scenarios.
Ask what else would be true
For each explanation, ask: if this were right, what else would I expect to see? Then look.
| Explanation | Evidence that would support it | Where to look |
|---|---|---|
| Pricing power | Price increases without volume loss; margin above peers | Management discussion, earnings calls, peer results |
| Lower input costs | Gross margin rising with a fall in raw material prices; peers improving too | Input price data, peer results |
| Spending cuts | Advertising or maintenance falling as a share of sales | Notes to accounts, expense breakdowns |
| Capitalised costs | Rising intangible or capital work-in-progress balances | Balance sheet and notes, as the accounting manipulation lesson explains |
| Mix shift | Segment margins stable but faster growth in the high-margin segment | Segment data |
Often one or two explanations survive and the others fall away.
Useful tie-breakers
- Peers in the same period. If every company in the industry improved, an industry-wide cause such as input costs is more likely than a company-specific one, as the comparing companies lesson explains.
- Base rates. How often do companies like this sustain such changes? Most margin jumps in commodity-using industries fade, for example.
- The company's own history. Has this happened before, and what followed?
- Timing. Did the change coincide with an event, such as a price rise, an acquisition, or an accounting change?
Why the first story is tempting
A story that explains the numbers feels convincing, especially after the fact, as the expectations lesson discusses. Several forces make the first story sticky:
- Confirmation bias: we prefer explanations that support our view, as the behavioural biases lesson explains.
- Management's narrative: companies naturally offer the flattering explanation.
- Correlation mistaken for cause: two things happening together does not mean one caused the other, as the correlation lesson explains.
When evidence cannot decide
Sometimes the evidence leaves two explanations standing. Then:
- Keep both, and reflect the uncertainty in your scenarios, giving weight to each.
- Note what future evidence would decide between them, and watch for it, as the what would prove you wrong lesson explains.
Why it matters
The explanation you accept shapes your forecasts and valuation. Accepting a flattering but wrong explanation, such as calling a temporary cost tailwind "pricing power", leads to paying for profits that will not last.
Limitations
Listing alternatives takes time, and evidence is often incomplete. Some explanations cannot be tested from public information. The aim is not certainty but a more honest weighing of possibilities.
Common mistakes
- Accepting management's explanation without testing it.
- Stopping at the first story that fits.
- Ignoring peers in the same period.
- Forcing a single answer when evidence is mixed.
Try it yourself
- Pick a notable change in a company's results, such as a margin jump or a sales surge.
- List at least four possible explanations.
- For each, write what else would be true and check whether it is.
- Write which explanations survive, and what future evidence would separate them.
Key takeaways
- Most trends in a company's results have several possible explanations. The first one that fits is often the one that matches what you already believe.
- List at least three explanations, including unflattering ones, before choosing.
- For each explanation, ask what else would be true if it were right, and look for that evidence.
- Peers in the same period, base rates from similar companies, and the notes to the accounts often separate explanations.
- If the evidence cannot decide, keep more than one explanation alive and reflect that uncertainty in your scenarios.
Check your understanding
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Terms used in this lesson
- Confirmation bias
- The tendency to seek, notice and believe information that supports what we already think, and to dismiss what does not.
- Base rate
- How often something happens in general. A success rate means little until it is compared with the base rate.
- Hindsight bias
- The tendency to believe, after an outcome is known, that it was predictable all along.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.