Uncertainty and Luck

The fundamental law of investing is the uncertainty of the future.

Peter Bernstein

Although clearly not a scientific law, the above is one of my favorite quotes about investing because the emphasis is rightfully on the unknowable future. There are no calculable answers, there are equally justifiable bull and bear arguments, as well as plenty of intelligent people looking at the same set of numbers and arriving at differing perspectives. For some, that’s deterring, but for others, like me, that’s motivating. Who is right? Only time will tell.

It’s widely recognized, and an understatement to say, that we are living through an historically unpredictable and unprecedented time with the COVID-19 outbreak continuing to spread, causing shelter-in-place orders to be extended and businesses to endure severe operational and financial stress. Whilst some believe shutting down the economy causes more harm than good, others believe the short-term pain is necessary to prevent even greater harm to humanity and economies. Regardless, the ongoing shutdown and its effects are real and must be factored into all investment decisions, though how much is debatable.

Clearly uncertain are the extent of the spread of the virus, the duration of the quasi-economic shutdown, the length and depth of the consequent recession, the sufficiency of government assistance, and the bumpiness of the road back to normal economic behavior. But first and foremost, this is a health crisis and the workers on the front line are performing heroic services to keep their fellow humans alive while risking their own safety. We are truly blessed to live in a world filled with so many empathetic and caring individuals. And whether or not appreciation is desired, it is warranted and recognition is the least that those of us on the sidelines can give. That, unquestionably, is not uncertain.

Over the past few weeks, questions have arisen to the effect of “How can you invest when you don’t know what will happen (with the virus, economy, companies, etc.)?” A good example is from a recent Value: After Hours podcast with Tobias Carlisle, Bill Brewster, and Jake Taylor, where a listener asked: “How do you value or buy a company right now without any idea what the earnings or financial metrics are?” The initial reactions were: Jake, “Amen” and Bill, “Well I think you’ve got to normalize it.” They all went on to have excellent, nuanced responses, and since I am only 1 of 10 listeners, I highly recommend listening and subscribing. 

In my opinion, these types of questions are somewhat ridiculous. Attempting to predict the unpredictable is irrational and of minimal value. The future is always uncertain; that’s what makes investing risky and unsettling. You never know what the numbers will be, nor should you! Market participants are always guessing, as are you. If certainty is required, less risky assets are a much better place to put your money. When it comes to buying businesses, intrinsic value is an estimate of all discounted future cash flows, of which none are known ahead of time. Of course, some companies provide guidance for a certain time period to establish a range of expectations. For companies that don’t, sell side firms perform research (mainly talking to management), whip up an uber-intricate model projecting the three financial statements for the next few years, and slap on a subjective terminal multiple of earnings and a buy rating. Of how much benefit to investors those estimates are I remain skeptical. Investing, or trading for that matter, based on quarterly or full year estimates is a losing game over time; any changes to those estimates will be picked up by algorithms way before you know what has happened. Besides, the numbers are a byproduct of the business’ economics, so time spent studying the business rather than the estimates will almost certainly prove more beneficial over the longer run. 

If the questions are about knowing what the actual earnings are, well, you’ll be waiting a long time if you didn’t invest until you knew the next quarter’s earnings. In regards to 2Q20, it’s well understood that for most companies the numbers will be horrible. How horrible is yet to be determined, but these aren’t normal business conditions so they will not be remotely representative of the business as a going concern – a point made by Bill as well. The advantage of normalizing earnings is to gain a picture of how a business performs over the full business cycle. Now that a recession is surely upon us, trough earnings and cash flows will seem wildly bearish. Of course this quarter doesn’t have to be trough earnings, nobody knows where the bottom is until after the fact. But many high-quality businesses have historically proven to be rather resilient through difficult times. So what good does it do to wait, especially since bargains will disappear once the uncertainty dissipates?

It’s vital to know what game you’re playing and why you think you have an edge in that game. When turmoil reigns, it’s easy to get swept up in the news flow and forget your playbook. Too many times investors attempt to become specialists in the subject related to the upheaval, whether it is derivatives, the macroeconomy, central banks, short-term money markets, FX rates, oil, or now, epidemiology. It’s tough to stay in your lane and admit you “don’t know” when clients are seeking answers, even if that is the correct response. Some traders have intricate knowledge of markets, the price levels buyers or sellers have previously come in at, the impact of market liquidity, dealer delta or gamma positioning, etc. with which to trade around. Some investors have intricate knowledge of companies, how sustainable the competitive advantage is (if there is one), how susceptible the business model is to various scenarios, how sticky revenues or customers are, how adeptly management allocates capital, etc. with which to invest around. If you’re an investor trying to play the trading game or vice versa, you’ll probably come out on the losing end. Again, everybody is just guessing. Buyers and sellers don’t have to come in at certain levels nor must a company’s competitive advantage prove to be impervious. The main difference is time horizon; different factors matter for different time periods. Generally, the shorter the time horizon, the greater the influence of noise on price fluctuations, causing luck to drastically outweigh skill. Over the longer term, though, skill matters tremendously.

For all the short-termism attributed to Wall Street, and justifiably so, in my opinion, the market does price in future expectations, but predominantly over-weights business conditions over the next 12 to 18 months. I don’t have any concrete evidence for that hypothesis, but I assume it’s because estimates are available and multiples are simple to use. Not to mention, projecting farther out is not practical given so much that can change, right? But that’s exactly what creates opportunities for those that do. The lifetime of the average business is much longer than a few years, so it seems odd to curtail estimates, even with the lack of clarity. Further, any business in a large market still operating 20 years from now is probably cheap no matter what the current price is. Time horizon is still an edge, but nonetheless requires superior judgment, and behavior.

Successful investing requires being non-consensus and right. In other words, your estimate of the future needs to be different and more accurate than the average. Think of the various combinations of precision and accuracy – you know, the pictures of the dartboard. If all the forecasts are precise and accurate, there is little reward for your accuracy; everybody wins. If others’ forecasts are accurate but imprecise, there is some reward for your accuracy. If other’s forecasts are not accurate, precision only matters at the margin; there is reward for your accuracy. The best opportunities arise when others are precisely wrong, but those are few and far between. Substantial disruptions cause heightened volatility, ambiguity, and dispersion in forecasts. Potential for reward. But simply the presence of greater than usual uncertainty does not mean it’s any easier for you to be more accurate than others. It requires skill to assess where the average stands and why you are correct to differ. 

Therefore, active investors should be salivating in a time like this, if they believe in their ability to perform quality valuation work. Swings in optimism and pessimism impact prices much more than changes in intrinsic value. In down markets, negative news covers the front pages, further declines seem all but justified and inevitable, and time horizons drastically shrink, likely prompting indiscriminate, non-fundamental selling to create dislocations between price and value. It may not be easy to recognize in the moment, but negative news inevitably leads to positive news before you know it. Envisioning a brighter future in the midst of darkness seems foolish yet can be quite rewarding if the negative news is fully discounted into prices and a rosier outlook is not. Stocks generally rise because either the actual numbers surpass the embedded expectations or the market is willing to pay a higher multiple of current estimates due to an outlook that’s better than the prior one. The more pessimistic the forecasts, the easier it is for companies to surpass expectations.

Although some investors claim to be clairvoyant, their riches come from suckers and not investment returns. You can either accept the truth that nobody knows how the future will play out, or waste $500k to find out. That doesn’t mean forecasting is therefore futile. Anybody can plug numbers into Excel to derive a value that fits their narrative, but assessing how realistic the numbers are is a worthwhile exercise. Companies with high multiples are usually fantastic, high growth businesses, whereas the opposite is likely true for low multiple businesses. But multiples, in and of themselves, do not signify a stock is expensive or cheap, simply where the market expectations stand. A high multiple may be warranted if the total addressable market and runway for value added growth might in fact be underappreciated. On the other hand, the future reality may be great, but not as incredible as expected, and the multiple must come down. Likewise, a low multiple may turn out to be justified if the reality turns out to be more unforgiving than the market forecasts. If not, then a re-rating may be in order. Multiples are just a shorthand for valuation, which always comes down to cash flows, growth, and risk. The key is to understand what factors most directly drive a business’ results and should therefore guide your estimates, while recognizing there are copious known unknowns, warranting a varying confidence interval. Moreover, assessing the uncertainty is one thing, reacting to it is another.

Which brings me to luck. Luck inexorably plays a role when making predictions, a prerequisite for estimating intrinsic values. Every intrinsic value estimate is wrong. But with a little luck, being less wrong than others is still rewarding. The impact of luck is also consistently underappreciated due to people’s knack for explaining history as foreseeable or expected. This is especially prevalent when it comes to markets and investing. First, the current situation we are living through is due to bad luck. The market turmoil and likely recession we are witnessing was not caused by economic overabundance, misallocation of resources, excessive leverage, extreme valuations, lack of or too strict regulations, central bank actions, government debt, algorithms, ETFs, or any other boogieman. A global pandemic isn’t cyclical in nature. It has happened before, though, and some presciently warned a deadly outbreak was inevitable and would be catastrophic, specifically originating out of China where wet markets with exotic animals that can carry such diseases are astonishingly a reality. But a viral outbreak is not a forecastable risk. Second, businesses forced to endure massive declines in demand, due to government-mandated policy, and individuals laid-off or furloughed as a result are unlucky, and thus deserve any and all aid to get through this extraordinarily painful period. Third, and most controversially, it’s equally unlucky for investors who are exposed to the hardest hit sectors. That being said, in no way am I excusing bad performance, saying stocks should never go down, nor that investing isn’t risky. Of course there is risk and uncertainty when holding financial assets; I’m simply pointing out that active investors hold a certain basket of companies based on their subjective investment theses, and sometimes those theses play out and sometimes they don’t.

When significant unforeseeable events unfold, as they sometimes do, it’s either lucky or unlucky, because it can’t be skillful. If, however, at the onset of such events, like this viral outbreak, an investor analyzed the potential ramifications and determined the market was under-reacting and adjusted their portfolio accordingly, that’s skillful. Largely, though, the effects are too arbitrary to consistently discount effectively. Furthermore, particularly after negative shocks that cause steep price declines, behavioral biases are heightened. Investors fear appearing wrong or not having factored a risk into their analysis, so they act like they knew it could happen. They then seek confirming evidence that their original thesis is still intact and conclude the stock shouldn’t be down as much as it is. It’s doubly painful to realize a loss, so might as well ride it out. The ability to be objective, chalk some gains or losses up to good or bad luck, and adapt your perspective to new facts is highly underrated.

As a mini case study, I’ll use the greatest investor of all time. In Buffett’s February 2020 interview on CNBC he said something that I don’t know he’s ever explicitly stated before (emphasis mine). 

“I watch everything. But I don’t do it to make in– specific investment decisions. I– it– but I– enjoy, I mean, I– wanna know what’s going on. But I also don’t think that I can make money by predicting what’s gonna go on next week or next month. I do think I can make money by predicting what’s gonna happen in ten years.

And the– long-term is very– in my view is very easy to predict in the general way. But an important way. I don’t think there’s any way to predict what the stock market will do ten minutes from now, ten days from now or ten months from now. So I work on what I think I’m able to do.”

It’s obviously implied by his writings and speeches, but due to the countless times Buffett and Munger have shunned the use of forecasts or predictions, I wondered how they could invest when it’s all about the uncertain future. The distinction, I realized, is between predicting the unpredictable, such as the stock market or macroeconomic gyrations, and assessing the somewhat predictable, the microeconomics of businesses. Buffett understands business models and consumer behavior so well that he feels comfortable making judgments about those farther out than the average market participant. He accepts there is uncertainty, but factors that in to the price he pays. And if he’s generally accurate that a business will still be making economic profits in 10 years, much longer than the average market participant is willing to project, he should make a lot of money. Buffett clearly knows what game he’s playing and what his edge is. 

However, nobody, including Buffett, is prescient. Berkshire recently sold 18% of its Delta holding and 4% of its Southwest holding. It’s somewhat surprising these rather modest trades received so much scrutiny, but when it’s the greatest investor of all time, and arguably a reversal of his stance from just a month prior, people take notice. Of course, these initial transactions may only be modest to bring his ownership percentage below a threshold for increased scrutiny, so he can either not be burdened by additional regulation or potentially, quietly liquidate more. But, Buffett selling? Blasphemy. I thought his holding period was forever. He’s lost it. Airlines are always bad investment. Or is it for regulatory reasons? Is he raising cash to make more attractive investments? Or will take one of them out? Speculation is entertaining, but it probably tells you more about the speculator than the subject matter; the only people who know the reasons are Buffett and Munger, and possibly Todd or Ted if one of the sales was either of theirs. I don’t have any superior insight, but Occam’s Razor suggests Buffett is trimming exposure in positions where the risk of permanent loss of capital has greatly increased. His first rule, after all, is to not lose money. He understands business models extremely well, and an airline without revenues is not even a cigar butt.

How did Buffett find himself with such large positions in currently horrendous businesses? Bad luck! Berkshire’s investments in the airlines were an opportunity to deploy a large amount of capital in a relatively cheap, concentrated, and modestly growing sector. Although historically a poor industry for investors, in recent years some of the airlines were shockingly generating value for shareholders (oil and gas companies take note). But after a viral outbreak caused a government-mandated economic shutdown, revenues are plummeting and with it their stocks and intrinsic values. Buffett has previously said the only things that worry him are cyber, nuclear, biological and chemical attacks, and although not man made, the impact of this unforeseen biological threat is wreaking havoc on many industries. After re-assessing the new reality, Buffett probably realizes his edge in predicting ten years out is drastically undercut now that near term liquidity and government aid are all that matter. Potentially, Berkshire’s ability to provide capital during stressful occasions will once again be rewarded, but Jason Zweig’s recent interview with Charlie Munger confirmed that calls to Omaha have yet to occur. It’s possible Berkshire could outright own an airline, but on his deathbed I don’t think Buffett would want to be remembered for one of his final purchases being an airline, given, you know, their history. 

As two additional examples, take the brick and mortar retail and cloud computing industries (disclosure: I am not an expert in either). An investor who’s thesis revolves around beliefs that the U.S. consumer is healthy, that not everything will be or can be bought online, and the valuations adequately compensate for the expected revenue declines, is unlucky to now witness forced store closures cause a cratering of demand. For retailers with an e-commerce presence, declines have been mitigated, but for those without one, bankruptcy is all too real. On the other hand, an investor who believes cloud computing will continue to gradually gain share from on premise data centers due to an evolution in computational capabilities and cost advantages, is lucky to see an economic shutdown create a surge in demand from remote related work. The cloud computing and “as-a-service” companies were already priced for growth, which could still be interrupted in the near term due to the financial stress that potential customers are experiencing, but nonetheless have seen massive boosts as facilitating remote work has become more necessary than previously forecasted. Although not perfect examples, they demonstrate how exogenous shocks have differing impacts on different sectors, unrelated to the initial investment theses. As a somewhat unreasonable hypothetical, what if instead of a viral outbreak infecting humans, it infected the airspace so that any wireless data transmissions were interrupted or unreliable? I’m sure the dialogue would be, “You can’t count on the internet/‘cloud’ for products/services, it’s unreliable! We’ve always done it in person/on premise for a reason. You’d have to physically cut these trustworthy cables!” And for investors, “The e-commerce/data center/cloud stocks were so highly valued based on an unreasonable future; obviously tech bubble 2.0, we should’ve seen it!” Price drives narrative and behavior. Will a snapback reversal occur if and when the economy returns to normal? Possibly. But a lot of damage and institutional decisions will occur in the interim. 

The game of investing involves embracing the uncertainty of the future and varying degrees of skill and luck. Although it’s much easier to invest based on quarterly earnings and let price drive narrative, you’ll always be a step behind. This pandemic, similar to all unknown unknowns, provides a great reminder of the benefits of balancing conviction and humility. Investing involves faith in your analysis, yet an understanding that there are inevitably external factors that will influence the range of outcomes. In times of significant uncertainty, the dispersion in forecasts becomes much more pronounced, enabling a greater likelihood of having a differentiating opinion. It’s because the future is unknowable that makes stocks volatile and predictions unreliable, but also accuracy rewarding. Just don’t let your accuracy fool you into thinking it was all skill; you might just get lucky.

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