value and opportunity

Every now and then some more or less famous investor is quoted with some common wisdom that rarely gets challenged but which in my opinion is total nonsense if used in the wrong context.

Example: “Picking up Nickels in front of a steam roller” should be generally avoided

This is a comment I often here when I discuss certain special situations like for instance the Stada case.

Those cases often look like this: with a relatively high certainty you get a relatively low return for a stock investment (let’s say 10%), however with a relatively small likelyhood you have to suffer a loss which is significantly higher (maybe -30% or so).

In isolation, it clearly looks like a real stupid idea to invest in something where the downside is 3 times higher than the upside. This is the opposite to a typical “lottery ticket” where you can “only” lose 100% but potentially gain many thousand of percent.

However the missing link is that most people don’t attach probabilities to those outcomes. If in my case from above for instance I would know that the probability is 80%, my pay-off would look like this:

In 80% of all cases I would earn 10%, whereas in 20% of the cases I lose .-30%.  So statistically, my expected value is (0,8*10% + 0,2*(-30%))= +2%.

Of course, if you invest in such a situation just once in your life, than it really looks like a bad gamble because the 20% loss probability could strike at the very first time. However if you do this more often, then the “law of large numbers” applies which says that if you would be able to repeat this investment over and over again, you would on average earn your 2% with a high certainty.

So the trick is for those investments that you should do this often in order to realize the expected returns.

One of the critical inputs in those cases is clearly the part with the probabilities for profit and loss. How do I know those in advance ? I think this is impossible to exactly know in advance but what one can do (and how most quantitative models work) is to build up a history and compare your assumption with the actual experience. If you made 20 investments where you assume on average a 80% chance of success and only 5 of them actually work out, you are either very unlucky or more realistically you have assumed the probabilites too optimistically.

“Asymmetric Upside potential”

Another interesting aspect is that because of psychological biases, investments that look like lottery tickets (or “asymmetric upside potential”) often show negative expected returns as people think that they are more attractive like for instance this article nicely summarizes:

Aversion to leverage means that investors typically shy away from borrowing money to invest, instead preferring to access implicit leverage through positions in more volatile securities.  The preference for lotteries means that investors tend to buy low priced, highly volatile stocks with the potential for huge returns, like lottery tickets.

Ultimately, this translates into more volatile stocks being overpriced relative to stocks with lower volatility, meaning that low volatility stocks often outperform on a risk-adjusted, and when levered on an absolute, basis.

Every traded call option has asymmetric upside potential but this is usually more than priced in. Clearly, if you can find mispriced call options you should buy them but they are very rare in my opinion.

On the other hand I do think that especially special situations with relatively low pay offs but a high certainty of success are potentially mispriced because investors don’t like this according to the prospect theory which in principle can be described as follows:

The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics.

The heuristic in this case is actually  “Don’t pick nickels in front of a steamroller” independent of the actual expected value of such a strategy.

Funnily enough, when I discuss these kind of situations in the blog, the interest of the readers is much higher in cases like Monsanto with large premiums (and large risks), compared to the smaller more certain cases.

Now one could argue: But how do you earn “equity returns” with those 2-5% expected return situations ? Well first of all the time horizon is usually less than a year, often only 2 or 3 months. Secondly, even if you don’t earn 10-15%, these kind of portfolio look very good at a risk adjusted basis.

Clearly after a 8 year bull market, no one cares that much about risk adjusted returns, but I still do. And I am pretty sure that good risk adjusted returns will turn into significant relative outperformance at some point in the future.

A similar common but similar stupid heuristic is: You should not short stocks because you can only gain 100% whereas your downside is unlimited. Again, like with special situations: What counts is what can you achieve in the long run based on the realized expected value and not the superficially unattractive profit/loss relationship.

Clearly shorting is not something for everyone and a lot of people don’t make money, but this is because short selling is really hard. However for those who possess this skill, this is clearly a very interesting source of alpha especially in a long/short setup.

Summary:

• Don’t rely on “common wisdom” investment heuristics
• an “asymmetric upside potential” itself is not a reason to buy if the price is wrong
• and collecting nickels in front of a steam roller done right can be a very profitable investment strategy if the price is right