How to keep a cool head when events get hot

Friday, Jun 18th 2021

Commentary

“The future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.” - Howard Marks

You don’t need to believe in multiverses to acknowledge that the world is infinitely complex, with an infinite number of variables and possible outcomes at play at any given moment. In the face of such complexity and unpredictability, we rely on a handful of techniques to help us make reasonable decisions and intelligent investments.

Among them is probabilistic reasoning: a means of estimating the likelihood of a given event. Of the outcomes that could occur, there are some which are more likely to transpire than others. The first time you heard about the concept of being struck by lightning, you were probably afraid: but once you were told the odds of getting struck (about 500,000 to 1), you likely ceased to be frightened by it. Similarly, investors are able to change their perception of a given event by using logic and math to estimate the likelihood of specific outcomes.

By using probabilistic reasoning, we are able to estimate not only the likelihood of a variety of outcomes, but also the impacts of those potential outcomes on a company’s intrinsic value. Accordingly, we are able to act, strategize, and invest more effectively.

For example, let’s say that “Firehose Utility Inc.” is efficiently priced at $100 on the stock market. Then, news breaks of potential regulation which would cut 50% of Firehose Utility’s intrinsic value. Following the news, the stock price drops to $60, as a result of investors who fear a 50% loss in their investment.

This is where probabilistic reasoning would come into play.

Let’s say that, in this scenario, we at Titan like the fundamentals of Firehouse Utility Inc., and have decided to conduct research on the name based on the price action. After due diligence, we conclude that there is a 20% chance for the “worst case” scenario to occur (decreasing intrinsic value by 50%), a 30% chance for minor regulation to occur (decreasing intrinsic value by 30%), and a 50% chance for regulation to not occur at all (resulting in no cut to intrinsic value).

Quick math applying the likelihood of each scenario to its adjusted intrinsic value would give us a weighted average intrinsic value of $81, well above the market’s initial reaction. This hypothetical scenario would present us with 35% upside to the current stock price of $60, or a 2-year internal rate of return of 16%.

As a result of probabilistic reasoning and after assessing the opportunity costs across other portfolio holdings, we might choose to invest in Firehose Utility. Where other investors panic, probabilistic reasoning can help you to stay focused, make educated estimates, and reach a weighted and informed decision.

Of course, there is no way to calculate the future with 100% precision. But probabilistic reasoning can help investors to evaluate potential outcomes and impacts with focus and rigor, enhancing their investment decisions.

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