Was my NAB analysis a waste of time?

Greg Hoffman recently completed a two-part review of NAB, here he explains how probabilistic thinking shaped this process.

What will NAB be worth in 2017? Part 2 was published a few days ago on Share Advisor (you can find Part 1 here). Two members have since questioned the value of the research, which means that I could have done a better job. This post is an attempt to clarify some key issues.

Warren Buffett has noted that the sharemarket is ‘frequently efficient’ (though not always) and this frequent efficiency has a logical implication for analysts; ‘Hold’ is very likely to be the correct recommendation for most stocks, most of the time.

Yet, in order to arrive at this rather humdrum stock recommendation, we typically go through detailed research in order to line up our valuation against Mr Market’s. Readers are usually spared the boring details but, every so often, we use a Hold recommendation to draw out analytical points that we hope will be instructive or enlightening.

So, having asked for 20 minutes of our members’ reading time to work through my two articles on NAB, what were the points I was attempting to make on the way to that final HOLD recommendation?

Case study

Firstly, I was using NAB as a case study of probabilistic thinking. Our culture places a high value on prediction—many people secretly (or even openly) hope that a ‘guru’ will light the way and show them exactly what the future looks like for any given stock.

Occasionally, in particular situations (such as the unwinding of RHG’s mortgage book), we’re able to do exactly that. Mostly, though, the future is too uncertain. And that uncertainty sets a few traps for investors.

Investing traps

One of these is the difference between our ‘best guess’ of what the future will look like and a probability-weighted analysis. A lot of people base their investment decisions on their ‘best guess’. This is a mistake. And a very expensive one on occasion.

Here’s a thought experiment to set the scene.

You have a choice between two games. Both involve paying $1,000 to roll a six-sided die:

Game 1: Roll a 6 and you’ll win $10,000 (plus get your $1,000 back). Any other number, you’ll lose your $1,000; or

Game 2: Roll a 6 and you’ll lose your $1,000. Any other number, you’ll receive your $1,000 back plus $250.

Here’s a table summarising the possible ‘net’ outcomes:

Result

Game 1

Game 2

1

-$1,000

 $250

2

-$1,000

 $250

3

-$1,000

 $250

4

-$1,000

 $250

5

-$1,000

 $250

6

 $10,000

-$1,000

 

You can see that the best guess (or most likely scenario) in each case is very different. In Game 1, you’re a 5 in 6 chance (greater than 83%) of losing your $1,000. In game 2, the odds of a $250 win are in your favour by that much. So which would you go for?

More importantly, which should you go for?

Doing the maths

To work it out mathematically, we need to take the mental step from ‘probability’ to ‘expectation’, which is the probability of a given outcome (1 in 6, in each case with both games) multiplied by its expected payoff. Then we add them all up for each game to determine the overall expectation.

Result

Game 1

Expectation

Game 2

Expectation

1

-$    1,000

-$             167

 $        250

 $                42

2

-$    1,000

-$             167

 $        250

 $                42

3

-$    1,000

-$             167

 $        250

 $                42

4

-$    1,000

-$             167

 $        250

 $                42

5

-$    1,000

-$             167

 $        250

 $                42

6

 $  10,000

 $          1,667

-$    1,000

-$             167

Total

 

$             833

 

$                42

 

This table makes it clear that the first game is a far superior proposition. Yet anyone simply using their ‘best guess’ analysis (based on the ‘most likely’ outcome) would opt for the second game.

Back to NAB

Relating this back to my NAB analysis, there are a couple of things I hoped to convey. The first is that our ‘best guess’ valuation for NAB is significantly lower than the current share price and our dividend expectations are way below most analysts’ forecasts. So we think the most likely outcome for somebody buying or holding NAB shares today is a poor one.

That conclusion would sit uneasily alongside our HOLD recommendation for anyone unaccustomed to probabilistic thinking. Why would you hold a stock when you think the most likely result is a bad one?

Hopefully the answer is now clearer after this little thought experiment.

Avoiding the Storm

Secondly, examining five very different potential future scenarios highlights the risks inherent in NAB (and virtually all bank stocks). The probability of a ‘wipeout’ is much greater for NAB (and the other banks) than for a more predictable beast like Woolworths, for instance.

This week, the ABC’s 7:30 featured a number of investors who lost substantial sums based on Storm Financial’s advice and strategies. These people were shocked, in large part, because they didn’t understand the disaster scenario up front. We want our members to avoid that potential fate with the big banks.

We hope that no member of Intelligent Investor Share Advisor would be totally stunned by, say, a 75% (or worse) share price fall in a banking stock. But judging by the output of more mainstream sources of advice, the average Aussie share investor could be forgiven for thinking such an outcome is impossible for a ‘blue chip’ bank stock.

Confronting the possibilities

This type of scenario-based analysis forces investors to confront the possibility of disaster as part of an overall process (even if they wish to assign a different probability to it than ours—hence the accompanying downloadable spreadsheet). We think that’s a healthy process which helps insulate us and our members from complacency about the risks involved.

If you find this area of finance of particular interest, I recommend Nassim Taleb’s book, The Black Swan. In it, Taleb highlights many of the traps we can fall into without the right mental tools to assess such situations correctly.

Please feel free to add your thoughts below regarding my analysis of NAB or the value of this type of analysis in general.

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