In a previous blog post, Digging Deeper, I discussed the often underappreciated downside of spending long periods of time analyzing a single stock. At its core, the issue relates to the diminishing marginal returns of in-depth analysis. That blog post touched on an interesting point, namely: is it possible, through spending greater amounts of time researching a stock, to uncover all the insights?
Investing can be thought of as making decisions about future outcomes with limited information. “Limited information” in this context can be mapped along a spectrum. At one extreme is the stock speculator: he or she may browse the financial press at best for stock ideas, and at worst will act off spurious stock tips. Their informational edge is very limited. At the other end of the spectrum is the analyst who has been following a stock for many years, and has done painstaking analysis into the fundamentals of the business to uncover little-known insights that could translate into an investing edge. Surely working harder to uncover all the insights will put you in the best position to generate robust investment results?
The answer is paradoxical in nature: gathering all the insights would be helpful, but gathering all the insights is also an impossibility, and thus foolhardy. This goes to the very heart of investing, and the challenges of incomplete information that investors must routinely navigate. Whether it’s due to information being kept internally by a company (i.e., private, and if material, illegal to trade on), or whether the insight concerns something that is unknowable (e.g., knowing if a natural disaster will strike a certain area), we will never have all the facts or insights around a given stock. Investors must resign to the fact that any investment will be made under conditions of varying uncertainty.
This notion of uncertainty goes to a fundamental aspect of investing: every investment decision is subject to risk, or in other words, the fact that there are many possible outcomes but only one will occur. This is in contrast to many other activities and professions. For example, a dentist is unlikely to be buffeted by the whims of chance when working on a patient. The dentist knows that if they follow the correct steps and procedures they should be able to remove a tooth with minimal fuss. There is a nexus between the skill of the practitioner and the outcome. In investing, that nexus is weaker, and the vicissitudes of chance are omnipresent, impacting investment outcomes in ways that may have been unexpected. However, this uncertainty can often create opportunity.
A past colleague used to say “you don’t get good news and good prices”. The inverse of this implies that good prices are typically accompanied by bad news. In situations where a company makes an unexpectedly negative announcement, stock prices can fall sharply to the downside. As the uncertainty reaches its crescendo, investors are typically greeted with favorable prices, and there is often an opportunity to profit handsomely for bearing this uncertainty. By the time more information comes to light, and the uncertainty of the situation has dissipated, it’s likely that the share price has already recovered, narrowing the opportunity for investment gain.
As is the case in investing, a formulaic approach is unlikely to yield foolproof investment results. In this instance, investing in every situation that exhibited highly uncertain outcomes could be perilous, and at worst catastrophic. Take for example the situation of PG&E (NYSE: PCG), the public utility that provides electricity and natural gas services across California. The Company was linked to the cause of the devastating California wildfires of 2018, and its stock price plunged. Many notable investment firms saw this as an opportunity to profit from a situation of great uncertainty, given the large stock price dislocation. However, saddled with more than an estimated $30 billion of wildfire liabilities, the company filed for bankruptcy in January 2019, generating steep losses for those banking on the opposite outcome.
Relying on hard and fast rules in investing might work in the short term, but it’s unlikely to provide a sustainable path to investment success. If investing in these sorts of highly uncertain situations was a guaranteed way to investment success, it would draw more capital from investors and thus limit any future opportunities.
There are few certainties in investing, but one of them is that every investment is subject to risk and uncertainty. One of the hallmarks of a skilled investor is making sensible decisions in spite of this uncertainty. While information gathering and analysis are critical to the investment process, and can help alleviate some of the uncertainty around an investment decision, we will never possess all the facts. Even if it were possible to know all the facts about an investment, this would still be no guarantee of investment profit. This brings to mind an example used by Howard Marks in his Risk Revisited Again memo:
I tell my father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Half way around the track, the horse jumped over the fence and ran away.
Much like the horse, markets can behave irrationally, and even when an investment prospect seems like a sure-thing, risk can intervene and change the expected payoff. It is for these reasons that investing is likely to remain as challenging and fascinating as it has in the past.
George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.