Imagine you were on the boats used by Columbus in 1492 or Magellan in 1519, largely credited as being the first practical evidence the world was round rather than flat.
Although it was already accepted that you wouldn’t sail off the end of the world if you headed too far east, there had not yet been any definitive proof. I’d bet there was at least one sailor who in their own dialect said something similar to ‘gee, I hope we’re right’ as they headed towards the horizon.
Value investing often feels a bit like that. We need to be confident in our ability to disagree with the market even though we can never be sure whether we're correct until many years later (and perhaps not even then).
There is no single event in the world — ok, perhaps the inevitability of death — where we can be completely certain of the outcome. A valuation is not a ‘static’ or absolute number. It’s an estimate of how much you believe a company is worth at a point in time based on a bunch of assumptions about the future.
However, this hasn't stopped many investors from falling victim to overconfidence and the illusion of control that a valuation or financial model can give.
You only have to consider former Queensland toll road operators Rivercity and Brisconnections, whose IPOs contained all manner of impressive and precise forecasts about daily traffic volumes, making financial success seem almost inevitable. The expected traffic never came and the companies soon went under.
Also consider once safe industries like the media industry. It wasn't long ago that the free-to-air television networks like Nine Entertainment Co. (ASX:NEC) and newspaper giants like Fairfax (ASX:FXJ) would have been considered high-quality companies. Investors would have felt comfortable forecasting future growth with confidence. However, pay-TV and the internet quickly eroded the relevance of these companies and today they are market pariahs.
Even subtle changes such as lower revenue growth or higher than expected costs can cause big problems for a company, especially if it has a large amount of debt or high fixed costs.
It's easy to fall in love with a valuation, especially after you've slaved away for hours modelling out earnings until the year 2050. However, the best thing an investor can do is accept that he or she will never get a forecast precisely right and that things will occur that you didn't originally consider.
Some businesses are more uncertain than others and it might be wise to make these 'risky' companies a smaller percentage of your diversified portfolio — as we advocate for our members through our risk ratings and recommended portoflio weightings. Also, if you're the type to build financial/valuation models, spend some time considering how small changes in key factors will impact the overall result and create best and worst case scenarios alongside your expected outcome.
Finally, accept that things will go wrong and be humble enough to change your mind when the facts change. That way you will be more likely to make it safely back to port rather than falling off the edge of the world. There are no awards given to investors who stubbonly stick with their opinions despite reality looking much different.