‘Wind extinguishes a candle and energizes a fire. Likewise with randomness, uncertainty, chaos: you want to use them, not hide from them. You want to be the fire and wish for the wind.’
Nassim Taleb
‘It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.’
Amos Tversky
‘There are two kinds of people who lose money: those who know nothing and those who know everything.’
Henry Kaufman
‘The fundamental law of investing is the uncertainty of the future.’
Peter Bernstein
‘Several things go together for those who view the world as an uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution and invest accordingly; insistence on defensive investing; and emphasis on avoiding pitfalls. To me that’s what thoughtful investing is all about.’
Howard Marks
In the last RE:VIEW (Volume 24, April 2013) Piet Viljoen’s piece ‘Investment Strategy in 2013 and Beyond’ noted investing in the face of uncertainty as one of the major challenges facing investors today. He suggested that investors devise a robust investment strategy to deal with this.
This article explores the concept of uncertainty further – highlighting that at times we may be aware of uncertainty to a greater or lesser degree, but that it’s present in all market environments. It speaks to why investors shouldn’t shy away from uncertainty and discusses more specifically what RE:CM views as a robust investment strategy.
Investing is necessarily about what happens in the future − but the future is uncertain. This uncertainty brings with it the risk of being wrong, or making mistakes. The media’s obsession with market darlings implies that investment success is almost exclusively about identifying the stocks that will be the ‘winners’ going forwards. However, avoiding big mistakes, which result in the permanent loss of capital, plays an even more critical role in determining long-term investment returns.
Long-term investment success is about avoiding the losers
Essentially, investing is a loser’s game. International investment advisor Charles Ellis (1975) uses the analogy of tennis to explain this. He points out that one game of tennis is played by professionals and a few gifted amateurs – and the other is played by the rest of us. ‘Professional tennis players stroke the ball with strong, well-aimed shots, through long and often exciting rallies, until one player is able to drive the ball just beyond the reach of his opponent. Errors are seldom made by these splendid players. Amateur tennis is almost entirely different. Brilliant shots, long and exciting rallies and seemingly miraculous recoveries are few and far between. On the other hand, the ball is fairly often hit into the net or out of bounds, and double faults at service are not uncommon. The victor in this game of tennis gets a higher score than the opponent, but he gets that higher score because his opponent is losing even more points. In other words, professional tennis is a Winner’s Game – the final outcome is determined by the activities of the winner – and amateur tennis is a Loser’s Game – the final outcome is determined by the activities of the loser.’
Investing is much like the amateur game − full of unanticipated developments and bad bounces. Even highly skilled investors can be guilty of mis-hits and overaggressive shots can easily lose them the match. Thus, defence – significant emphasis on keeping things from going wrong – should be an integral part of every investor’s game.
This is especially true due to the powerful benefit of compounding returns off a higher base by avoiding substantial losses. Over time, this has a significantly greater impact on generating returns than managing to pick a few ‘winners’. The perceived ‘winners’ are also likely to be overpriced in the short-term and can turn into big losers overnight if investors overestimate the momentum and popularity of these stocks and buy them at very expensive levels, only to have them correct to more realistic levels thereafter.
Acclaimed value investor Howard Marks agrees with this saying: ‘The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor.’
Short-term uncertainty creates opportunities for long-term investors
Uncertainty often brings the benefit of presenting very attractive opportunities for investors who are able to look past short-term volatility in market prices and instead focus on long-term investment prospects. This can be difficult because portfolio managers who underperform the market risk losing assets and ultimately their jobs. As a result, many won’t buy a contentious stock that they think presents attractive prospects over a three-year horizon because they have no idea whether or not the stock will perform well over a three-month horizon. For this reason, inefficiencies present themselves in the market. These can be taken advantage of by a disciplined investor who is truly able to invest with a long-term investment horizon.
An example of this was when RE:CM, attracted by extreme pessimism and bad news, began hunting in Greece in late 2011 for high quality businesses which may have been indiscriminately sold off along with the rest of the market. We found only a handful of businesses that met our quality criteria – two such examples being Coca Cola Hellenic and Hellenic Exchanges. Unsurprisingly, both were trading at incredibly low prices relative to our calculations of their intrinsic values.
Chart 1: Coca Cola Hellenic and Hellenic Exchanges Share Price Movement (US$)
Source: Thomson Reuters Datastream
As Chart 1 shows, despite no fundamental improvement in the macroeconomic situation in Europe, both these counters have performed well from those initial levels. Both suffered further price declines after we bought the stocks however, before recovering and going on to deliver superior returns over the full period. Such short-term price declines are undeniably uncomfortable. But, assuming our work in identifying the stocks as undervalued is correct, these are temporary losses of capital that we’ll ultimately recover. This is very different to the permanent loss of capital an investor experiences when overpriced stocks correct to more realistic levels.
Forecasting the future increases your probability of being wrong
How do investors typically deal with the complicated issue of investing for an uncertain future? Most spend immense resources and time trying to anticipate the future by forecasting.
We’ve explained many times why we believe attempting to forecast the future is futile. To summarise:
- Most forecasts are merely extrapolations of the present
- Every now and then something truly unexpected happens and it’s at these times that accurate forecasts would have been of the greatest value;
- It’s also at these times that forecasts are least likely to be correct;
- While it may be possible that some forecasters will forecast such an event, it’s unlikely to be the same people consistently.
Yet most analysts still spend much of their time forecasting variables such as revenue estimates. This is despite their dismal record of forecasting over both the short and long-term. According to analysis by value investment firm GMO’s James Montier (2010), two-year forecasts of company earnings were on average wrong by a staggering 93%. Even when forecasting the next year’s earnings, which analysts would theoretically have the best chance of calculating correctly, they were wrong by 47%!
In Europe, the numbers were similar. The average 24-month forecast error was 95%, and the average 12-month forecast error 43%.
Chart 2: Analyst Forecast Error
Source: Montier (2010)
Their performance in predicting the longer-term future was no better. Comparing analysts’ five-year growth rate forecasts to actual outcomes showed that the stocks expected to grow the fastest actually grew no faster than the stocks expected to grow the slowest. Forecasting the future, given this dismal track record, significantly heightens an investor’s probability of being wrong and thus cannot be seen as a viable step towards creating robust investment portfolios.
Accurately forecasting the future of an entire economy has proven similarly unachievable. Even the US Federal Reserve, relied upon by the entire world to give insight into where the US economy is heading, has a dire track record of projecting variables such as economic growth. Dylan Matthews of the Washington Post (2013) tracked the Fed’s projections for every June forecast from 2009 to 2013. Each forecast included projected growth for the year in question and two years after. The results in Chart 3 show that the Fed forecasts became less optimistic over time, but were still always wrong. For example, in 2009, the Fed was predicting 4.2% growth in 2011. In 2010, it revised that down to 3.9%. In 2011, it revised it further to 2.8%. Ultimately, the economy only grew 2.4% that year. The Fed initially projected growth almost twice as fast as the actual figure.
Instead, acknowledge what you don’t know and work with what you do know
If we accept that the future is largely unknowable, we can find other ways to cope with this outside the false comfort of making forecasts that are unlikely to be of any value. Overestimating what you’re capable of knowing can be extremely dangerous, but acknowledging the boundaries of what you’re able to know, and working within those limits, can give you a significant advantage.
As difficult as it is to understand the future, it isn’t that hard to understand the present and the past. We can make good investment decisions by observing both, eliminating as much as possible the need to guess about the future. We can make assessments about where we are in the cycle for instance, which can give us great insight as to how we should be positioned, without making a call on the timing of how such a cycle will play out.
Chart 3: The Spotty Track Record of the US Federal Reserve’s Economic Projections
Source: Washington Post, Federal Reserve
Our approach involves building portfolios of high quality assets acquired at times when these are cheap relative to their intrinsic value. Theoretically, this value is determined by discounting future cash flows to the present. However, if it’s not possible to forecast these cash flows accurately, how do we calculate such a value?
We determine intrinsic value using sensible methods and realistic assumptions
Our approach is to make assessments based on a thorough grasp of the economic situation in which a company currently finds itself. We calculate what we believe to be a sustainable level of earnings, adjusted for cyclical low or high points and extraneous events. We can base these assessments on the business’s unique drivers and competitive advantages through its barriers to entry.
This approach puts more emphasis on the information about the firm that is solid and more certain and values the company’s future prospects with more realism and less optimism than is typical in the industry.
We approach company valuations by progressing from most to least concrete information, starting with two methods originally advocated by Ben Graham, one of the forefathers of value investing.
Method 1: Asset value
Assuming we’ve taken the time to understand a business fully, we should at the very least be able to value its assets as a solid underpin to our calculation of the business’s worth. If a business has no barriers to entry, it’s worth no more than the replacement value of its assets – or in the case of a business in decline, the liquidation value of the assets.
We work our way down the list of assets on the balance sheet, accepting or adjusting the stated numbers as required for the most realistic portrayal of value. We do the same for the liabilities side of the balance sheet and subtract this value from assets to obtain the current net asset value. There’s no need for us to forecast the future as the assets and liabilities exist today and many of them are tangible and can be valued with reasonable accuracy.
Method 2: Earnings power value
The second method advocates calculating what Graham termed the Earnings Power Value (EPV) of a business – namely the value of its current earnings, properly adjusted. This assumes that:
Current earnings, properly adjusted, correspond to sustainable levels of distributable cash flow; and
This earnings level (or Earnings Power) remains constant for the indefinite future.
We then discount the Earnings Power by the cost of capital to give an estimate of value. EPV has the advantage of being based entirely on currently available information, which means it remains uncontaminated by more uncertain conjectures about the future. For EPV to be greater than the value of its assets however, the business needs to have a demonstrable barrier to entry that is likely to remain into the future. We use the EPV method for most of the businesses we value, since our emphasis is on quality companies that have a clear barrier to entry, which we believe will allow the business’s ‘Earnings Power’ to persist into the future.
Growth is the variable most prone to error in valuing a business
When does future growth feature in calculating intrinsic value? We’re very cautious in factoring growth into valuations because it’s the most difficult variable to estimate. Uncertainty about future growth is usually the main reason why value estimations are prone to error.
Often, we find it useful to reverse-engineer what the current market price is implying about the future growth of a company and then ask whether this is realistic or not given the growth rates the company has achieved over time. This allows the analyst to assess how likely (or otherwise) the implied growth rate is.
A good example of this in practice was our analysis of Microsoft in mid-2011 when we first considered the stock as a potential investment idea. As Chart 4 shows, at the time the share price was around $26. This price implied that the business was in perpetual decline and earnings would have a negative growth rate of 3% a year. Given that Microsoft is a high return business with significant barriers to protect those returns, we held the view that it was by no means going backwards in terms of growth. Instead, we believed that a growth rate similar to GDP (approximately 4% per annum) would be more realistic for a company of this nature. We saw an opportunity to invest in a fantastic global business at a substantial discount to intrinsic value as a result. The share price has re-rated somewhat since we initially invested but even at current prices, the market is still pricing in less than our GDP growth estimate and we maintain a position in the stock, resized for the smaller discount to fair value.
Chart 4: Microsoft Share Price (US$)
Source: Thomson Reuters Datastream
A robust portfolio requires a disciplined approach which applies criteria consistently
Permanent investment principles are an important aspect of ensuring robustness and consistency in investment decision-making. Our awareness of the uncertainty we encounter isn’t constant. Despite the fact that uncertainty is constantly present, it doesn’t tend to feel that way. Our emotions tend to sway and distort our perceptions of risk and often do so in a counter-constructive manner. So, in addition to focusing on a sensible method of deriving our estimate of intrinsic value, we also use a number of other tools to ensure discipline in applying our investment principles consistently:
1. A clear and constant definition of ‘quality’
At RE:CM we prefer to invest in high quality businesses because even if our calculation of intrinsic value turns out to be wrong, a quality business can grow into the price we paid over time – thus minimising the risk of permanent capital loss.
However, much like emotions lead investors to feel more or less uncertain about the future, perceptions of quality also change depending on what has done well in the past. If the share price of a company has performed poorly, investors inevitably associate the business with this disappointing performance, irrespective how the fundamentals – the underlying business itself – may have done. For this reason, it’s important to have permanent criteria for what we deem to be quality and to stick with this throughout market cycles, ignoring subjective measures of popularity.
We define a quality business as one that has proven its ability to produce returns over and above its cost of capital historically. Of particular importance however, is for us to be able to point to a permanent, demonstrable barrier to entry that suggests this will be the case going forward.
2. Considering risks we do know about
Renowned investment thought leader, Nassim Taleb in his book ‘Antifragile’ (2012) says, ‘You cannot say with any reliability that a certain remote event or shock is more likely than another (unless you enjoy deceiving yourself), but you can state with a lot more confidence that an object or a structure is more fragile than another should a certain event happen.’
At RE:CM, we think carefully about the worst-case scenario for every investment we make. By being aware of some of the more specific risks in the environment, we can assess how ‘fragile’ our investment is to these risks in particular. For instance, when deciding whether to invest in the Greek stocks mentioned earlier, we identified as a key risk the possibility of Greece’s expulsion from the EU and the return of the drachma. This would result in debt default, currency debasement and higher inflation. We looked at other instances of sovereign debt default in Argentina (2001) and Russia (1998) and the impact these had on those markets at the time. As a result of this analysis, we decided that we’d only invest in companies with:
Net cash on the balance sheet or low levels of gearing with true long-term domestic debts; and
Assets and cash flows that could maintain their intrinsic value in global terms.
3. Learning from experience
Making mistakes is inevitable – learning from them is also crucial to building ‘antifragile’ portfolios. We have a ‘graveyard’ where we examine the investment theses and outcomes of securities over the full ownership cycle. Each ‘tombstone’ examines the successes and mistakes from the inception of an idea to selling out of the position. We analyse whether our thesis played out as anticipated, or whether something happened that proved our investment thesis to be incomplete or ‘fragile’. Learning from our mistakes and successes is another key aspect to ensuring the continuing robustness of our portfolios.
Risk controls are necessary throughout – even in good times
During good times, it’s very difficult to ascertain whether risk controls are adequate. At RE:CM, we define risk as the possibility of permanent capital loss. This isn’t observable until it collides with negative events. We spend a lot of time thinking about how to minimise this potential for loss.
It’s important to recognise that risk may still have been present even if no loss occurred. The absence of loss doesn’t necessarily mean a portfolio was safely constructed. In order for a portfolio to make it through all market environments including tough times, risk has to be well controlled. In good times however we can’t tell whether risk control was present but not required, or completely lacking.
It takes bad years for the value of risk control to become evident in reduced losses. The cost of risk control – in the form of return foregone – can unfortunately seem excessive during the good years but this makes it no less necessary.
Investors need to be compensated for the risks they bear
The key is how to bear risk intelligently for profit? Howard Marks, chairman and co-founder of Oaktree Capital Management, uses the example of how life insurance companies – some of the most conservative companies in America – manage to provide life assurance when they know that everyone dies: (2011)
It’s a risk they’re aware of (everyone dies)
It’s a risk they can analyse (through medical tests)
It’s a risk they can reduce through diversification (by ensuring a diversified mix of policyholders)
It’s a risk they can be sure they’re well paid to bear (by pricing premiums appropriately).
At RE:CM we follow a similar approach. We try to make sure we’re aware of the risks in any investment thesis, knowing full well that unforeseen negative events are always a possibility. We analyse the risks we can identify and diversify the portfolio with numerous bottom-up investment ideas that aren’t all predicated on a single top-down overall theme. We only invest when we’re convinced the likely return will more than compensate us for the risk taken. This means investing with a sufficient margin of safety – where the price is trading at a discount of 50% or more to intrinsic value.
A robust portfolio is the most sensible way to deal with the risk of uncertainty
Putting together a robust portfolio means we accept that uncertainty is a constant and we don’t know what will happen in the future. Our conviction is that the best way to protect portfolios against unforeseen negative events is to buy securities, preferably of high quality businesses, and only when they’re very cheap compared to what they’re worth. We look to fill portfolios with as many diversified investments as we can find so that investment success is never dependent on any one of these ideas playing out perfectly. Ultimately, this puts the odds of investment success on our side, despite the uncertainty of the future.
References:
Ellis, C. (1975). ‘The Loser’s Game’. Financial Analysts Journal, vol. 31, no. 4: p. 19-26.
Marks, H. (2011). The Most Important Thing – Uncommon Sense for the Thoughtful Investor. New York: Columbia University Press.
Matthews, D. (19 June 2013). ‘This graph shows how bad the Fed is at predicting the future.’ Washington Post. Available from : www.washingtonpost.com/blogs/wonkblog/wp/2013/06/19/this-graph-shows-how-bad-the-fed-is-at-predicting-the-future/ (accessed 8th July 2013)
Montier, J. (2009). Value investing – tools and techniques for intelligent investment. Chichester: John Wiley & Sons, Inc.
Taleb, N. (2012). Antifragile – Things that Gain From Disorder. New York: Random House Inc.
