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Investing Amid a Rising Range of Outcomes
The Q1 market selloff was broad-based and intense, fueled by deep uncertainty about the pandemic’s true threat. In our view, the market did little to discriminate among individual firms, preferring to re-rate sectors given the short timeframe, rapid price action and lack of information.
Of course, our process is built to capitalize on market dislocations, when fear and uncertainty dominate, as is the case in our current environment. But we are also vigilantly risk-aware. This is where a thoughtful and repeatable process makes all the difference.
Clearly, the markets are navigating a series of risks for which history is a poor guide. We can’t reasonably draw on prior experiences because there are none. Without a reliable empirical guide, we are operating with a high level of intellectual honesty about what we do know, about what we might not know, about what we can know, and about what we can’t know all that well. Working within our process, we focus on understanding the range of potential outcomes and look for opportunities where the asking price today tilts in our favor. And currently, the range of outcomes may never have been wider in our time as professional investors. Not only is the range wider, the left-tail of the distribution—the one with the worst outcomes—is fatter than usual; the right-tail of the distribution—the one with the best outcomes—may not be similarly wide.
Dispersion and skewness are useful statistical concepts, but like any tool, only as good as the skill and judgment of the analyst. These objective tools can help to push emotion and cognitive biases aside, but we don’t approach the opportunity set with a math-explains-all approach. Rather, we use statistics to amplify our judgment. Our probabilistic thinking is one prime example.
Investing is not gambling, but they share some common traits. Consider a pair of fair, six-sided dice. If you were offered a chance to wager on the outcome of a roll of those dice, you absolutely must first know how many outcomes are possible: 11 with 36 possible combinations. We think exhaustively about the paths and permutations an out-of-favor stock can take. But what makes the current environment particularly challenging is that the game isn’t with two dice. Now, it’s more like a three-dice game, with 16 outcomes, across 216 combinations.
Going to 16 outcomes from 11 certainly raises the level of difficulty. When the range of outcomes widens even modestly, the possible combinations expand exponentially. This intuition is simple, but powerful. If you focus only on the range of outcomes and ignore the complexity in the combinations of paths that get you there, then you could be left bearing unintended risks. Consider how a company not only needs resilience in this economic downturn, its survival may depend on bridging a liquidity gap, which means navigating a dysfunctional financing market where central banks are now the activist investor. Such a path is complex and fraught with uncertainty. Given those conditions, a risk-aware value investor must recognize this and adjust valuations and expectations accordingly.
Our process relies on investing with a margin of safety. Those safety elements aren’t foolproof in times like these or under these conditions, but they are intellectually honest, based on sound principals and time-tested.
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