Causation

Causation is the direct link between a cause and its effect, where one event is the genuine reason another happens. In the world of investing, this concept is both incredibly simple and fiendishly difficult to master. It stands in stark contrast to its deceptive cousin, correlation, which merely indicates that two things happen to move together, without one necessarily causing the other. Mistaking correlation for causation is perhaps the single most expensive intellectual error an investor can make. It's the “post hoc ergo propter hoc” (Latin for “after this, therefore because of this”) fallacy in action: thinking that because your favourite sports team won the championship right before your portfolio soared, the victory somehow caused your financial success. For a value investing practitioner, the entire discipline is a hunt for true, durable causes of business value, while rigorously ignoring the siren song of spurious correlations that echo through financial media.

Imagine you notice that every summer, ice cream sales and shark attacks both spike. A naive analyst might conclude that eating ice cream causes shark attacks! This is, of course, absurd. The two are correlated, but they don't cause each other. A third, hidden factor—warm weather—causes both. People swim more and eat more ice cream when it's hot. This same logical trap is everywhere in finance.

• A company's stock price jumps 10% the day after its CEO appears on a popular TV show. Did the interview cause the jump?
• A stock plummets after a negative article is published. Did the article cause the drop?

The answer is often more complex. The CEO's interview might have simply coincided with the release of a fantastic earnings report, which was the true causal driver. The negative article might have only gained traction because it highlighted a real, underlying problem in the company's balance sheet that savvy investors were already beginning to notice. The value investor's job is to be the detective who ignores the noise (the correlation) and finds the real culprit (the cause).

To succeed, you must move beyond asking “what” happened and relentlessly ask “why.”

Quantitative data is the starting point, not the destination. When a company's revenue grows by 20%, that's an effect. The crucial task is to uncover the cause. A successful value investor digs deep into a company's story by reading its annual reports (like the 10-K in the U.S.), listening to management calls, and studying the industry. Is the revenue growth caused by:

• A new, revolutionary product that is delighting customers? (A strong, positive cause).
• Aggressive, one-time price cuts that are destroying profit margins? (A weak, negative cause).
• The bankruptcy of a major competitor, leaving a market vacuum? (A good, but possibly temporary, cause).
• A new, efficient distribution system that provides a lasting economic moat? (An excellent, durable cause).

Understanding the quality and durability of the cause is the heart of fundamental analysis.

Be on guard for these mental shortcuts that can lead you astray:

• The Narrative Fallacy: As humans, we are wired to seek stories. We see a stock chart wiggle and instinctively weave a narrative to explain it: “The stock fell because of geopolitical tensions.” While possibly true, it's often an oversimplification. Many market moves are random noise. The best investors are comfortable saying, “I don't know why it moved,” and refocusing on the business fundamentals, which are the true long-term drivers.
• Data Mining: This is the practice of torturing data until it confesses to a pattern. If you test hundreds of variables against a stock's past performance, you will inevitably find some that show a high correlation—like the height of the CEO or the day of the week. This is a classic backtesting trap. These accidental correlations have zero predictive power because they are not causal.
• Ignoring the Base Rate: This involves getting swept up in a specific, exciting story while forgetting the underlying statistics. A new electric vehicle startup may have a charismatic founder and a soaring stock price (the apparent cause-and-effect). But an investor must remember the base rate: the vast majority of startups, especially in capital-intensive industries, fail.

You don't need a Ph.D. in statistics to think clearly about causation. You just need the right mental models.

Formulate a clear investment thesis. This is your hypothesis. For example: “I believe this company's new patent will create a monopoly, causing its profits to double in five years.” Then, actively seek evidence that could disprove your thesis. This intellectual honesty, a cornerstone of the scientific method, protects you from confirmation bias and helps you stress-test your causal assumptions.

The ultimate causes of long-term investment success are found in the business, not the market.

1. Durable Competitive Advantages: What protects the business from competition?
2. Competent and Honest Management: Are the leaders skilled operators with integrity?
3. A Sensible Price: Is there a sufficient margin of safety between the price you pay and the underlying value you are getting?

These factors are what cause a business to generate cash and create value for its owners over time. Everything else is largely a distraction.

As the great investor Charlie Munger advises, “Invert, always invert.” Instead of only asking, “What will cause this investment to succeed?” also ask, “What could possibly cause this investment to fail?” By thinking through the potential causes of ruin—a change in technology, a new competitor, a catastrophic management blunder—you gain a much deeper and more robust understanding of the investment's risks and the true drivers of its potential success.