Uncertainty, both imminent and resolved, has been on my mind these last two weeks. I posted my valuation of Valeant on April 20, making the argument that, at least based on my expectations on what could be revealed in the delayed financial filings, the stock was worth about $44, approximately $12 more than the prevailing stock price. Many of you were kind enough to comment on my valuation, and one of the more common refrains was there were too many unknowns on the stock to be taking a stand. In fact, one of the comments on the post was that "regardless of the valuation, a sufficient margin of safety does not exist (on the stock)". On April 21, we got news that Volkswagen had come to an agreement with US authorities on the compensation that they would offer buyers of their cars and a day later, the company announced that it would take an $18.2 billion charge to cover the costs of its emissions misrepresentations. It was a chance for me to revisit my valuation of Volkswagen, in the immediate aftermath of the scandal in October 2015, and take stock of how the the investment I made in the stock then looks, as the uncertainty gets slowly resolved. All through these last two weeks, there were signs that Yahoo's journey, that was starting to resemble the Bataan Death March lately, was nearing its end, as the company reviewed bids for its operating assets. Since it is a stock that I valued almost two years ago (and bought after the valuation) and labeled as a Walking Dead company, I am interested, both financially and intellectually, to see how this end game plays out. As I wrestle with the resolution of uncertainties from the past and struggle with uncertainties in the future on every one of my investments, I thought it would be a good time to look at good and bad ways of responding to I uncertainty in investing and valuation.
The Uncertainty Principle
Uncertainty has always been part of human existence, though it has transitioned from the physical uncertainty that characterized the caveman era to the economic uncertainty that is more typical of today, at least in developed markets. Each generation, though, seems to think that it lives in the age of the greatest uncertainty. That may be partially a reflection of a broader sense of "specialness" that afflicts each generation, where it is convinced that its music and movies were the very best and that it had to get through the biggest challenges to succeed. The other is a variation of hindsight bias, where we can look at the past and convince ourselves that what actually happened should have been obvious before it occurred. I am surprised at how many traders, investors and portfolio managers, who lived through the 2008 crisis, have convinced themselves that November 2008 was not that bad and that there was never a chance of a catastrophic ending. That said, uncertainty not only ebbs and flows over time but also changes form, making enduring fixes and lessons tough to find. As investors bemoan the rise of uncertainty in today's markets, there are three reasons why they may feel more under siege now than in prior decades:
- Low Interest Rates: In my post on negative interest rates, I pointed to the fact that as interest rates in many of the leading currencies have dropped to historic lows, risk premiums have increased in both stock and bond markets. The expected return on the S&P 500 in early 2008, before the crisis, was 8% and it remains at about that level today, even though the treasury bond rate has dropped from 4% to less than 2%, but the equity risk premium has risen to compensate. Even though the expected return may be the same, the fact that more of it can be attributed to a risk premium will increase the market reaction to news, in both directions, adding to price volatility.
- Globalization: Globalization has not only changed how companies and investors make choices but has also had two consequences for risk. The first is that there seem to be no localized problems any more, with anyone's problem becoming everyone's problem. Thus, political instability in Brazil and too much local government borrowing to build infrastructure in China play out on a global stage, affecting stock prices in the rest of the world. The second is that the center of global economic power is shifting from the US and Europe to Asia, and as it does, Americans and Europeans are starting to bear more of world's economic risk than they used to.
- Media/Online Megaphones: As an early adopted of technology, I am far from being a Luddite but I do think that the speed with which information is transmitted around the world has allowed market risks to go viral. It is not just the talking heads on CNBC, Bloomberg and other financial news channels that are the transmitters of these news but also social media, as Twitter and Facebook become the place where investors go to get breaking investing news.
The Natural Responses to Uncertainty
Much of financial theory and a great deal of financial practice was developed in the United States in the second half of the last century and therein lies a problem. The United States was the giant of the global economy for much of this period, with an economy on an upward path. The stability that characterized the US economy during this period was unusual, if you look at long term history of economies and markets, and much as we would like to believe that this is because central bankers and policy makers learned their lessons from the great depression, there is the very real possibility that it was just an uncommonly predictable period. That would also mean that the bedrock of financial practice, built on extrapolating from past data and assuming mean reversion in all things financial, may be shaky, and that we have to reevaluate them for the economies that we operate in today. It is unfair to blame the way we deal with uncertainty entirely on the fact that our practices were honed in the United States. After all, it is well chronicled in both psychological annals and behavior studies that we, as human beings, deal with uncertainty in unhealthy ways, with the following being the most common responses:
- Paralysis and Inaction: The most common reaction to uncertainty, in my experience, is inaction. "There is too much uncertainty right now to act" becomes the refrain, with the promise that action will come when more of the facts are know. The consequences are predictable. I have friends who have almost entirely been invested in money market funds for decades now, waiting for that moment of clarity and certainty that never seems to come. I have also talked to investors who seem to view investing when uncertain as a violation of value investing edicts and have found themselves getting pushed into smaller and smaller corners of the market, seeking elusive comfort.
- Denial and Delusion: At the other end of the spectrum, the reaction that other investors have to uncertainty is go into denial, adopting one of two practices. The number crunchers fall back on false precision, where they add more detail to their forecasts and more decimals to their numbers, as a defense against uncertainty. The story tellers fall back on story telling, acting as if they have the power to write the endings to every uncertain narrative, when in fact they have little control over either the players or the outcome.
- Mental Accounting and Rules of Thumb: The brain may be a wondrous organ but it has its own set of tics that undercut investing, when uncertain. As Richard Thaler has so convincingly shown in his work on mental accounting, investors and analysts like to use rules of thumb, often with no basis in fact or reality, when making judgments. Thus, a venture capitalist who is quick to dismiss the use of intrinsic value in a young start-up as too fraught with estimation error, seems to have no qualms about forecasting earnings five years out for the same company and applying a price earnings ratio to those earnings to get an exit value.
- Outsourcing and Passing the Buck: When stumped for answers, we almost invariably turn to others that we view as more knowledgeable or better equipped than we are to come up with solutions. Cynically, you could argue that this allows us to avoid taking responsibility for investment mistakes, which we can now attribute to consultants, text book writers or that person you heard on CNBC.
- Prayer and Divine Intervention: The oldest response to uncertainty is prayer and it has had remarkable staying power. There are large segments of the world where big investment and business decisions are preceded by prayers and divine intervention on your behalf.
If the first step in change is acceptance, I have come to accept that I am prone to do some or all of the above, when faced with uncertainty, but I have also discovered that these reactions can do damage to my portfolio.
Dealing with Uncertainty
To reduce, if not eliminate, my unhealthy responses to uncertainty, I have developed my own coping mechanisms that will hopefully push me on to healthier tracks. I am not suggesting that these will work for you, but they have for me, and please feel free to modify, abandon or adjust them to your own needs.
1. Have a narrative: As many of you who read this blog know, I have long believed that a company valuation without a story to bind it together is just numbers on a spreadsheet and a story that uses no numbers at all is a fairy tale. There is another advantage in having a narrative underlie your valuation and tying numbers to that narrative. When faced with uncertainty about specifics, the question that I ask is whether these specifics affect my narrative for the company and if yes, in what way. In my valuation of Volkswagen, right after the diesel emissions scandal, I did not find a catastrophic drop in value for the company because my underlying narrative for Volkswagen, that of a mature business with little to offer in terms of expansion or growth opportunities, was dented but largely unchanged as a result of the scandal. With Valeant, in my November 2015 valuation, I argued that the attention brought to the company by its drug pricing policies and connections to Philidor would result in it having to abandon its strategy of growth driven by acquisitions and growth and to shift to being a less exciting, lower growth pharmaceutical company. That shift in narrative drove the inputs into my valuation and my lower assessment of value.
2. Categorize uncertainty: Uncertainty can come from many sources and it is useful, when valuing a company in the face of multiple uncertainties, to classify them. Here are my groupings:
Since it is easy to miss some uncertainties and double count others, I find it useful to keep them isolated in different parts of my valuation:
Specifically, in my Volkswagen and Valeant valuations, it was micro risk that concerned me, with some of that risk being continuous (the effect of the diesel emissions scandal on Volkswagen car sales) and some being discrete (the fines levied by the EPA on Volkswagen and the risk of default in Valeant). That is why both companies, at least in my conventional valuations, have low costs of capital, notwithstanding the risky environment, but their values are then adjusted for the expected costs of the discrete events occurring.
3. Keep it simple: This may seem ironic but the more uncertainty there is, the simpler my valuation models become, with fewer inputs and less levers to move. One reason is that it allows me to focus on the variables that really drive value for the company and the other is that it reduces my need to estimate dozens of variables in the face of uncertainty. Thus, in my valuations of start-up companies, my focus is almost entirely on three variables: revenue growth, operating margins and the reinvestment needed to sustain that growth.
4. Make your best estimates: As I start making my estimates in the face of uncertainty, I hear the voice in the back of my mind pipe up, saying "You are going to be so wrong!" and I silence it by reminding myself that I don't have to be right, just less wrong than everyone else, and that when uncertainty is rampant, most investors give up.
5. Face up to uncertainty: Rather than cringe in the face of uncertainty and act like it is not there, I have found that it is freeing to admit that you are uncertain and then to take the next step and be explicit about that uncertainty. In my valuations of tech titans in February 2016, I used probability distributions for the inputs that I felt most shaky about and then reported the values as distributions. Since some of you have been curious about the mechanics of this process, I will take a lengthier journey through the process of running simulations in a companion piece to this post.
6. Be willing to be wrong: If you don't like to be wrong, it is best not to value companies in the face of uncertainty. However, if you think that Warren Buffet did not face uncertainty in his legendary investment in American Express after the salad oil scandal in 1964 or that John Paulson knew for sure that his bet against the housing bubble would pay off in 2008, you are guilty of revisionist history. There is a corollary to this point and it relates to diversification. As I have argued in my post on diversification, the more uncertain you feel about individual investments, the more you have to spread your bets. It is not an admission of weakness but a recognition of reality.
If you are a value investor, you will notice that I have not mentioned one of value investors' favorite defenses against uncertainty, which is the margin of safety. Seth Klarman is one of my favorite investment thinkers but I am afraid that the margin of safety, at least as practiced by some in the investing community, has become an empty vessel, an excuse for inaction rather than a guide to action in risky times. I will come back to this measure as well in another post in this series.
If you are an active investor, you are constantly looking for an edge, something that you can bring to the table that most other investors cannot or will not, that you can exploit to earn higher returns. As the investing world gets flatter, with information freely accessible and available to almost all investors, and analytical tools that anyone can access, often at low cost, being comfortable with uncertainty may very well be the edge that separates success from failure in investing. There may be some who are born with that comfort level, but I am not one of them. Instead, my learning has come the hard way, by diving into companies when things are most uncertain and by valuing businesses in the midst of market crises, "by going where it is darkest". That journey is not always profitable (see my experiences with Vale as a precautionary note), sometimes makes me uncomfortable (as I have to make forecasts based upon little or bad information), but it is never boring. I am wrong a hefty percent of the time, but so what? It's only money! I am just glad that I am not a brain surgeon!
- DCF Myth 3: You cannot do a valuation, when there is too much uncertainty
- The Margin of Safety: Excuse for Inaction or Tool for Action?
- Facing up to Uncertainty: Probabilities and Simulations
Introductory Post: DCF Valuations: Academic Exercise, Sales Pitch or Investor Tool
- If you have a D(discount rate) and a CF (cash flow), you have a DCF.
- A DCF is an exercise in modeling & number crunching.
- You cannot do a DCF when there is too much uncertainty.
- The most critical input in a DCF is the discount rate and if you don’t believe in modern portfolio theory (or beta), you cannot use a DCF.
- If most of your value in a DCF comes from the terminal value, there is something wrong with your DCF.
- A DCF requires too many assumptions and can be manipulated to yield any value you want.
- A DCF cannot value brand name or other intangibles.
- A DCF yields a conservative estimate of value.
- If your DCF value changes significantly over time, there is either something wrong with your valuation.
- A DCF is an academic exercise.