Luis García Álvarez, CFA at MAPFRE AM
Does COVID-19 change the way we value companies?
I can tell you that the short answer is no. Still, I hope you will continue reading the rest of the article. The world is an uncertain place. This has always been the case and I am not sure that the moment we are living in is characterized by much greater uncertainty than others in the past. And while many of us are quick to classify this pandemic as a “black swan,” it is not.
One of the conditions that a black swan has to meet is to be a highly unpredictable event. Just watch some of the videos that have been circulating on social networks during these months to realize that several people, from various health experts to Bill Gates to Nassim Taleb, had been warning about this risk for some time.
A few days ago, I received an email with an advertisement about a virtual seminar titled “Valuation of companies in times of uncertainty.” Although it may be a good sales hook, the fact is that it is redundant. Investing involves making decisions in environments of uncertainty. That’s how it always is. While making predictions is extremely complicated, as investors, we cannot avoid having to act on our perceptions of a future we do not know.
Valuation of companies: risk or uncertainty?
To explain how we value companies and make investment decisions, it’s worth first distinguishing between two relevant concepts that are sometimes intertwined. I am referring to the uncertainty mentioned above and to risk. Contrary to what is sometimes thought, these factors do not always have to be related.
Imagine that you are offered to pay 10 euros to take part in a game. With a 50 percent probability, you will win 20 euros. Also with a 50 percent probability, the prize will be 100 euros. There is a lot of uncertainty in this game, as it’s difficult to predict what the outcome will be. However, there is no risk, since no money is lost in any case.
Now let’s change the rules. Imagine that you are again offered to pay 10 euros to take part in a game. On this occasion, with a 95 percent probability you will lose your money, while there is a 5 percent chance of winning 200 euros. Now the uncertainty is very low, but the risk of losing our money is really high.
Risk and uncertainty management tools
Uncertainty relates to the difficulty of predicting what exactly will happen in the future. Risk, for its part, is determined by the price we accept to pay for taking part in a game in which the result is uncertain. They are two different enemies. Each one appears at a different time within our process and the weapons to fight them are not the same.
When analyzing a company, uncertainty is presented to us when we try to discuss the possible scenarios we face (how much will sales grow, and what will their margins be?) and to determine the likelihood that each of them will happen. We need these steps to estimate what reward we can expect (the value of the company). The way to manage uncertainty is to try to select the best information, study and expand our circle of competence. With better data and greater knowledge, we won’t eliminate uncertainty, but we can significantly reduce it.
Even so, we must never underestimate our ignorance. There will always be things that we do not know, and accepting this can protect us. Mark Twain said, “It ain’t what you don’t know that gets you into trouble; it’s what you know for sure that just ain’t so.” Investors cannot escape uncertainty. It is an uncomfortable companion who will not disappear, so we must learn to live with it by trying not to cloud our thinking and without losing our humility.
Risk, for its part, appears when deciding what price to pay for an asset. It is an enemy against which there are more concrete weapons. The main weapon we use as value investors is the “safety margin.” Accepting that uncertainty accompanies us and that we will make mistakes in our estimates, we require a discount for what we think a business is worth.
Charlie Munger explained that he and his partner Warren Buffett are looking for “a horse that has a 50 percent chance of winning with a payoff that is at least three to one.” Value investors have a risk aversion (to losing money) and we always try to pay a price much lower than the expected reward. If this strategy is successfully repeated several times, the statistics will be favorable.
When we talk about the target price, it’s a different conversation
This difference between the price and the value of an asset is a two-sided coin. On the one hand, there is the safety margin and, on the other, the revaluation potential. While the safety margin tells us about the discount on the price paid versus our valuation, the revaluation potential goes the opposite direction. In other words, it tells us how much the price of an asset can rise to what we think it is really worth.
When I participate in investment conferences in various locations, there is an anecdote that is frequently repeated. On many occasions, an attendee will ask what our target price or estimated revaluation potential is for a company or for our portfolio as a whole. In these situations, I tend to disappoint them because, personally, I do not believe in the usefulness of these concepts.
The valuation of a company is never an exact point, rather it’s a range. Usually, it is a sufficiently wide and non-linear range so that it no longer makes sense to talk about revaluation potentials. Although these are common in the industry, even among managers and analysts I admire, they can lead to confusion and a false sense of security (it is not uncommon to even see target prices with several decimal places).
Our goal is simple. We try to reduce uncertainty through analysis, control risk by avoiding overpaying and buy businesses that are significantly more valuable than the price we pay. Exactly how much more is not the question that concerns us the most. Even if it is uncomfortable, we cannot escape uncertainty.