I came across this technique when I was studying for my MBA last year and has found them to be very useful when it comes to investing.
Many times, we as investors, have failed to ask relevant pertinent questions causing the underlying reasons for the companies we are interested or vested in. Even though it appears that most investors have done the first level of due diligence by screening check the financial numbers, many failed to consider the underlying root cause that explains why the share price of the company may be languishing where they are at the moment.
This is where the 5 Whys Technique might prove to be useful in investing. Mathematicians called this the power of second derivative thinking. In simple terms, it means going beyond the first level screening where everyone is able to see or figure out. This makes sense because in investing, you need to be able to think and prospect ahead of the pack (mostly retail investors or research brokerage analysts) and take action before they do in order to earn higher than average returns. Otherwise, you’ll be better off investing in an ETF index fund for longer sustainable returns.
The 5 Whys technique was formally developed by Sakichi Toyoda and first used within the Toyota Motor Corporation during the manufacturing evolution decades ago. They are an iterative question-asking technique used to explore the cause and effect relationship, each depth going deep and deeper to uncover and determine the underlying root cause of the problem. They are important in investing because for most of the times, the underlying root cause to the problems are not so formally evident at an investor’s eyeball level. They require the tenacity of the investor’s persistence in asking the right questions and the ability to see what is ahead in order to make a calculated risk return assessment on whether the investor should buy the share at present.
Let’s take a look at an example:
1st Why – Q: Why do you write a blog?
A: Because I want to document my journey towards financial independence.
2nd Why – Q: Why are you seeking financial independence?
A: Because I want the freedom to do things that I love.
3rd Why – Q: Why do you want the freedom to do things that you love?
A: Because my current job does not satisfy me, but money is an issue.
4th Why – Q: Why is money an issue?
A: Because my current expenses are exceeding my current income.
5th Why – Q: Why are your expenses higher than your income?
A: Because I have a family of 6 to feed and I am the sole breadwinner of the family.
This is just a very simple example but you can see how each questioning uncovers the underlying root cause of the problem as the question moves along.
We can also apply the same to investing.
1st Why – Q: Why are you interested in Keppel Corp?
A: Because they are trading at an “attractive” low P/E valuation.
2nd Why – Q: Why are they trading at such valuation?
A: Because the share price has gone down more than the drop in earnings.
3rd Why – Q: Why did earnings (and share price) goes down?
A: Because their O&G segments are dependent upon the oil price.
4th Why – Q: Why did oil price drop?
A: Because there is an oversupply and alternative replacement of shale gas.
5th Why – Q: What is the tolerance level of sensitivity of oil price the business can take the hit? Can oil goes back to pre-crisis level?, etc etc…
I think by now you should get the idea of how you can use the 5 Whys technique. You can modify or customize it to your liking, but the idea is to get a deeper understanding of the underlying root cause before you decide to action.
What do you think? Is this useful to you? Do you conduct second derivative thinking when analysing companies?