Saturday, September 25, 2010

uU Investing

I just read a fascinating essay that really resonated with me, it's called "Investing in the Unknown and Unknowable," by Richard Zeckhauser. It can be found here:

Basically, the article asserts that by seeking out situations where the outcome is unknown and unknowable (uU) an investor can potentially make outsized returns. Now let's look at an example of what a uU investment is and what it isn't:

I don't know exactly what Coke's (KO) finances are going to look like in 5 years, but I know the company is still going to be selling sugar water and I can make a reasonable guess about their cash flow - this is NOT a uU investment.  IMO the large integrated banks, such as Citigroup, Bank of America, or JP Morgan, are great examples of uU investments. I have no insight into potential government regulation and capital requirements, and coming up with an estimate of their loan losses is quite difficult. In other words, these companies are "black boxes." Further, I have no idea what the economy will look like - will we be in the middle of a "lost decade" like Japan in the 90's, or will be experiencing devastating inflation, like the late 70's?

The problem with investing in the Coke's of the world is even though I can come up with a good estimate of their fair value, so can everyone else. In other words, even if I decide Coke is undervalued and therefore an attractive stock, there's someone on the opposite side of the trade who did the same analysis and decided Coke was overvalued - and she's probably smarter than me (having gone to Harvard or Wharton for her MBA).  And it's not just the Coke's of the world, there are very smart people EVERYWHERE in investing; and they're arb'ing away the pricing inefficiencies in small-caps, micro-caps, bonds, distressed debt, etc. - this is why it's so hard to beat the market consistantly and over long periods.

BUT if I decide to invest in a big bank I don't have this problem, i.e. everyone is having a huge degree of difficulty figuring out their fair value - so what type of environment does this create? Well, I think people in general have a natural aversion toward uncertainty, so a lot of current holders are dumping their stock. Additionally, our friend with her Wharton MBA isn't interested in buying these stocks - afterall if she's wrong she is subject to "Monday morning quarterback" risk, which in the investment world can get you fired.  In other words, uU investing sidesteps the normal mechanisms that generally keep securities priced efficiently.

If you already read the linked essay you'll notice the author makes a strong case for Warren Buffet being a uU investor.  You can also make the case that Mohnish Pabrai with his "low risk, high uncertainty" mantra fits in this camp.  Morningstar's fund manager of the decade Bruce Berkowitz is also a uU investor: he's investing in the banks right now, he invested in health care companies while (i.e. not after) the government was overhauling health care, he owns stocks like SHLD, JOE, LUK, and FUR - all of which are classic uU stocks.  And of course there are many other value investors who are also uU investors in disguise: David Tepper, Ian Cumming, Michael Burry, Prem Watsa, Seth Klarman, Carl Icahn, etc. etc. 

This brings me to my next point: I love it when I hear value folks talk about whipping out Excel, plugging in financial statements, explicitly projecting bull/bear cases for 7 years, trying to figure out the right cost of equity (BTW it's 12%, it's always 12%), and then passing b/c there's too much uncertainty.  Rather I'd argue, for some portion of their portfolio, investors should seek out uncertainty, try to quantify the downside (or like B. Berkowitz says, "Kill the company"), make sure you're not overpaying, and let the upside take care of itself. 

As for my portfolio, I consider LUK, SD, and HAWK to be uU stocks to one degree or another.  On my watch list I'd consider CHK, NRG, BH, FUR, SHLD, TTT, MFCAF, BAC, COF, and JPM to be uU's.  Of course it's tricky figuring out what to buy, but if you go several posts back I disguss my checklist, which is my starting point.