As I was writing this, I got Vitaliy Katsenelson’s latest article on J.C. Penney.
If Katsenelson is a new name to you, he is a prominent investor and fund manager in the value investing community. He is also the author of Active Value Investing where he introduces the Absolute PE model which I’ve modified and incorporated into the OSV Stock Analyzer.
The article Katsenelson wrote was based on the errors of investing in J.C. Penney Company, Inc. (NYSE:JCP), but the main point he was conveying was the use of probabilities and position sizing.
Something that isn’t discussed enough.
What I can say is that by including it into your analysis, your decisions become more systematic, emotionless and low risk.
Investing is a Probabilistic Adventure
I don’t think buying the department store chain’s shares was a mistake. Investing is a probabilistic adventure: You assess upside and downside probabilities of a potential investment, and if at the end the balance is significantly favorable, you pull the trigger. – Source
One of the many reasons why Warren Buffett is so successful at what he does is because he is a probability machine. He is able to internally calculate the probabilities of every investment opportunity and act accordingly.
His love for Bridge isn’t surprising because it’s a game where the most successful players are able to judge mathematical probabilities to beat their opponents.
Same concept with poker.
Not only are you forced to bet based on the probabilities, a strong mental state is required to win at it.
David Einhorn is an avid poker player, even going to Las Vegas to participate in poker tournaments. One thing that he wrote was that every investor should play poker, just to learn about themselves.
Poker tends to bring out your inner enemies to the surface.
- If you believe that you are good at analyzing, poker will show you that you suck
- If you believe that you are able to keep calm in the face of losses, poker shows you that you suck
- and the list goes on
My tip is for you to download a poker game on your phone or play it from facebook and play like it’s real money. Then you’ll see what you need to work on when it comes to investing too.
Back to probabilities.
The Forgotten Analysis of Looking at Probabilities
Let’s say you found a hidden gem, read the reports, identified the risks, listened to management, and calculated the intrinsic value.
Everything points to a buy.
So what happens next?
An order is placed based on how confident you feel about the company.
But there is an additional step that gets forgotten just before the buying phase.
What Buffett says is that you should weigh the probability that certain events will or will not occur.
Simple Probability Questions You Should Ask Yourself Before Buying Anything
Let’s look at Apple Inc. (NASDAQ:AAPL).
By running reverse valuations, you are forced to think and answer simple probability type questions.
- What is the chance that the stock price is due to a deterioration of the business?
- What is the probability that Apple will not be able to meet the market expectations?
- How likely is it that growth will be negative?
- What is the likelihood that FCF will grow xx% over a 5 year period?
Simple questions that a professional analysts wouldn’t bother asking.
But these are fundamental questions to make rational decisions.
Thinking in terms of probabilities has its advantages. You end up focusing on the longer term instead of quarterly or annual numbers.
I could have easily answered the question of “will Apple Inc. (NASDAQ:AAPL) exceed market growth expectations this year?” with a no, ultimately not buying the shares.
But when you articulate the question, it ends up coming out to be something like “will Apple exceed current market growth expectations in the next 3 years?”, my answer turns into a yes, and I’m more than happy to hold and ignore the short term noise.
A More Concrete Probability Calculation with InfuSystem
A practical example of applying probabilities comes from analyzing risk arbitrage special situations.
Let’s pick apart my failed arbitrage in Infusystem (INFU) to see what I mean.
INFU Outcome Table
This table shows how I viewed the end result. I placed a bet that there was a 70% chance of the deal going through and doubled down.
Boy was I wrong about that.
For what it’s worth, once the buyout was canceled, the stock price did fall back to $1.50 on the first day, but with disappointed investors, the stock price fell to as low as $1.30.
INFU after the Buyout is Canceled
If something like this happens to you, your gut tells you to take the loss and walk away.
It’s what most people think as you can see from the comment I was getting.
Use people’s reaction as a contrarian signal
My bet that the deal would go through was incorrect, but my bet that InfuSystem Holdings Inc (NYSEMKT:INFU) was worth more was not.
The investor trying to buy out InfuSystem offered a lowball offer of $1.85 to $2.00. Management came back and said the business was worth more.
So in this case, which probability is higher?
- Probability A: Stock is worth less than $1.50
- Probability B: Stock is worth at least $1.85
I placed more odds that option B is correct and bought a little more during the fall.
As mentioned before, thinking in terms of probabilities helps you stay focused and see beyond short term cycles and criticism.
But Your Probabilities are Wrong
In case I’m drawing up a dreamy picture of limiting downside by slapping on probabilities to everything, I want to bring up some realistic view points.
Probabilities are going to be incorrect most of the time.
In Katsenelson’s article, he mentions that he thought J.C. Penney Company, Inc. (NYSE:JCP) had a 70% of tripling versus a 30% chance of dropping 40%.
We believe position sizing should be driven not by reward but by risk. J.C. Penney Company, Inc. (NYSE:JCP) had a terrific upside, but it still had a 40 percent downside, with a meaningful 30 percent probability. However, when we sold the stock at a loss, the impact on the total portfolio was less than 1 percent.
The trouble is that quantifying 70% or 30% is impossible.
Random events cannot be quantified.
Then what’s the point?
The alternative method that I apply