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Confusing Uncertainity With Risk

March 4, 2011 Leave a comment

Here is an extract from the article ‘ Investors will miss out if they confuse uncertainity with risk ‘ by Whitney Tilson published in the Financial Times on 16 Feb 2008.I think confusing uncertainity with risk is precisely what happened pre-budget in India this year. And this confusion is something that happens to a greater or lesser extent every year before the budget.The same thing happens before the final decision is taken on any government policy. So if a stock investor remembers that there is a difference between uncertainity and risk he/she can sometimes buy shares cheap.Risk means the chance of a loss of capital. Uncertainty is the range of different outcomes. So a stock may have high uncertainty but may not be risky, if no one knows what will happen but the worst case scenario would not results in a huge loss.

“Dealing with uncertainty is always a key challenge for investors. But dealing with uncertainty doesn’t mean avoiding it – on the contrary, it is often fuzziness about a company’s future that creates the type of opportunity bargain-hunting investors cherish.Wall Street in the main hates uncertainty, which manifests itself in depressed share prices of companies whose prospects lack “visibility.” But where the market can err is in confusing uncertainty with risk. Just because a company’s future is highly uncertain doesn’t mean an investment in it is risky. In fact, some of the best potential investments are highly uncertain, but have little risk of permanent capital loss. As hedge-fund manager Mohnish Pabrai describes it in his book, The Dhandho Investor: “Heads, I win; tails, I don’t lose much.”

Among the many case studies Pabrai presents is the investment he made this decade in the funeral-home operator Stewart Enterprises. Following a debt- fuelled consolidation of the funeral-home sector, Stewart and other big players found themselves too leveraged as the economy soured. Stewart’s shares, as high as $28 in 1998, had fallen below $2 by the fall of 2000, trading at a minuscule price/earnings multiple of only three times.

While the market appeared to be betting on Stewart’s demise, Pabrai’s research indicated otherwise. Funeral homes were actually among the least likely businesses to fail, as non-price-sensitive customers and less-than dynamic competition resulted in stable profitability and growth over time. Stewart was producing positive free cash flow and had hard assets such as land and funeral-home properties valued conservatively at $4 per share, twice the share price at the time.

Stewart still faced great challenges in managing its crushing debt load, but Pabrai did what all smart investors do in dealing with the uncertainty the company faced: he identified the various ways the story might unfold and assigned probabilities to each.

He concluded that there was an overall 80 per cent probability that the company would deal with its debt problems in one of a few ways, in each case resulting in a doubled share price within two years. If the company went bankrupt – a scenario he assigned a 19 per cent chance – he believed the hard assets would more than cover the debt, leaving at least $2 per share in equity value. He saw only a 1 per cent chance of permanent loss of capital from the share price going to $0.

Given the 80 per cent chance of doubling his money and only 1 per cent chance of losing it all, Pabrai took the bet. While there was real uncertainty over exactly when and howthe story would play out, he saw the risk of a permanent loss as extremely low. What happened? Soon after his purchase of Stewart shares, the company announced that it planned to sell international assets – which comprised about 20 per cent of revenues and produced little cash flow – to pay down debt. By March 2001 the company had paid down more than $50m of its debt and cash flow remained healthy – to which the market responded, taking the share price above $4. His target price reached, Pabrai sold……………………”