Earlier in my career I worked for one of Australia’s most successful professional gamblers. He taught me to think of the world in terms of probabilities as a way to find mispriced bets – ones where the offered odds more than compensate for the risks. This way of quantifying uncertainty is a key tenet of investing, but I learned this is not the way to value stocks.
For you to estimate the intrinsic value of a company using probabilities you need to judge a variety of outcomes and what you’ll earn under each scenario. The problem is that not only are we guessing about what the outcomes will be, but also how certain we are and therefore what probability should be assigned to each case.
You can see how we recently used probabilities to weigh up the various outcomes and payoffs of investing in McMillan Shakespeare here, though this is a rare situation. McMillan will potentially suffer a large drop in profits if Kevin Rudd is re-elected and his legislation regarding novated leases is enacted.
Humans are known to be very poor at forecasting the future - we tend to simply extrapolate our recent experiences. So, rather than use probabilities to value a stock, I prefer to think about how much I could lose and what protection I have.
You can find protection in various forms, such as reliable earnings, pricing power, a competitive moat, or a balance sheet loaded with valuable or highly liquid assets. The best protection of all is buying at a large discount to intrinsic value, net tangible assets or perhaps liquidation value.
Analysing a company as though it were about to go into liquidation is the most conservative measure. Any price you pay above that demands an increasing number of implicit assumptions about the company as a going concern. For example, if you value a stock highly because earnings are growing, ask yourself what competitive advantage is protecting those earnings? What if a competitor starts to slash prices or a new technology leaves you obsolete? What if a financial crisis removes your ability to roll over debt? The more you pay above liquidation value, the less protection you have from factors such as increased competition.
‘Intrinsic value’ is not a precise figure to several decimal points; a company has different values depending on your assumptions. The price you pay relative to those potential outcomes is what determines whether you are gambling or investing.
As an individual investor it’s very hard to know when you’ve got an edge based on favourable odds. However, you can build a margin of safety into your assumptions sufficiently conservative to minimise losses. That’s why value investing works – you are betting with an edge that you have created by thinking independently, doing your homework, and finding opportunity in the fear and greed of other investors.
My time as a professional gambler didn’t teach me to think about stocks in terms of probabilities. What I learnt was that to really profit from an uncertain world, your biggest bets should be those with the greatest downside protection.