Estimating the intrinsic value of a company cannot be done with precision. That is why we use a range. Companies have very different probability distributions of values, with different investing implications.
Q2 2020 hedge fund letters, conferences and more
Value Range Distributions - Behavioral Value Investor
Let's talk about value ranges, how to think about them, how to connect them to the types of companies that we are considering investing in, and basically how to use them in our intrinsic value investing process.
Hi, my name is Gary Mishuris. I'm the Managing Partner and Chief Investment Officer of Silver Ring Value Partners. I also teach the value investing seminar at the F.W. Olin Graduate School of Business. So I've been thinking recently about value ranges. And I think part of it is, you know, I've over time evolved as an investor, hopefully. a little bit better, you never know, you know, maybe worse in some ways, but I'm hoping it's for the better.
I think that as my journey as a value investor has continued, I have gotten to have a deeper understanding of value ranges. And so I think, you know, if you were to trace a typical value investor. Now, when they start, they think, no, they're probably not even think of value ranges. They just think, oh, there's a value, you know, it's 100. And my goal is to buy something for 60 or something like that, like the classical Ben Graham approach.
That's not to say Ben Graham doesn't think of the ranges or anything like that. But I think people kind of think of a point estimate, because we humans are not very good at probabilities or probability distributions. We like to think concrete specific terms. Terms, so okay, company's worth $100 or 100 million dollars, whatever, right. And then I think people get to the point where they think the range and the range has, there is a confidence interval, right? There's a worst case, there's a best case and those two endpoints determine, the two kind of ends of the interval. And then probably there is a base case or the most likely case in the middle somewhere.
I think people kind of think about that in two dimensions. Or maybe if they think about two dimensions, they kind of picture a bell curve, right? And maybe there's a 90% confidence interval. You know, using a bell curve, you kind of think of the base case of being kind of between the best and the worst. And that makes sense that makes sense for a number of businesses, but I want to talk about in this video is that that's not the only value range that you can have, right? You don't have to have a very symmetrical value range. And I think that you might have a range, no, that has a fat tail with the direction.
So let's think about a business, which has a fat right tail. What do I mean by that? What I mean by that is that there is a reasonable probability, you know, it's not necessarily 50 or 60, or 80%, but still not an insignificant probability that a business might be far more valuable than your expected value. So what do I mean by that? So I mean, the classical one type of that is literally a lottery ticket right? A lottery ticket would have a payoff profile where most likely you will, you know, get nothing if you get something you get a little bit most of the time, but once in a blue moon, you get a huge windfall.
So that's interesting, but it's not, It's for me, it's not necessarily my favourite type of business. I mean, so I think that caters more to someone who is more interest in speculating the stocks rather than investing. But what if you had a business, which had a value range characteristics where, under most scenarios, it's worth a decent amount. So under almost no conceivable scenario is worthless or worth very little, it's worth a decent amount under a lot of the probability distribution. But in maybe 10-20-30% of the probability distribution, it's worth 3-4-5x or 10x, what's your expected value is for the business.
Now that gets interesting. And I think the way you think about investing in that business is a bit different than maybe in a more traditional business with a symmetrical distribution of probabilities between the best and the worst case and I think in some sense If you're not paying anything extra for that, you want to seek out businesses where they can become much more valuable as events unfold. And then I think you have to track your thesis and track how events develop, because you want to understand is that possibility.
So if you have this, let's say 20% chance that, you know, let's just use simple numbers, you know, let's say your base case is businesses worth 100. The worst case you think is 50. But the best case, maybe the best case is is worth 500. Right? So that's the tale that you have more room for upside to the value and the downside. That doesn't necessarily mean it's going to get realizable tomorrow. It's going to take time and years to figure out we know how this is going to play out.
As you track the thesis as quarters and years come out, you might want to update your kind of your assessment because what if the business is tracking in the path where it's, you know, more likely than not to not be worth 500 rather than a 100. As the evidence accumulates, and it's rarely one thing is usually a number of cumulative things that you have to wait to reach that conclusion, you want to update your value range, you want to update the probability distribution.
And I think it's a classical mistake that at the beginning and intermediate value investors make is that they stick to their original value range. Stock goes up, let's say the stock doubles and they're like, man, I doubled my money.
That's awesome. I'm gonna sell, you know, I'm just too scared to hold on. And I think a lot of times that might be right, and we'll talk in a second about a different probability distribution, where that is exactly the right thing to do. But if the stock has doubled, but now the probability is, you know, much more likely that's worth 500 rather than a 100. You don't want to sell it 200. Right. You want to take your time.
So I think that, you know, you want to seek out those businesses. And what does that mean? You know, how do you find those businesses? Usually, they come in the form the nature of the business itself, there might be some inflection point in the economics of the business beyond a certain point, or from the management team, and the management team being able to create additional value down the road with a new business, a new product line, and a trading market and so forth.
And you know, initially when that hasn't happened yet, you might not give a lot of weight to the probability. But when that evidence starts to occur, that it is happening, and now it's much more likely, you need to be mindful of that. And by the way, it's nice to seek out businesses where not too much terrible can happen to them. But a few good things they're not completely unlikely, might make them worth a lot more.
So that's one type of probability distribution. That's not usually thought of by people in terms of the value investing community. Another probability distribution is, what is aspect of one, is how narrow or why there's that range, right? So you know, so you take some businesses, you really have no idea what the value ranges, you might say, qell, some of the things is zero and, you know, $200 a share?
Well, gee, yeah, that feels great. It's not. But there are other businesses, which are pretty predictable, where the range is very narrow. And maybe the range might be and by the by narrow. I don't mean that it's way low. Between $8 and $12, a base case of 10, that there's almost no business like that. And if you think you're that good at estimating business value, you're either like the best investor out there, or you're fooling yourself. And I'll let you decide which one it is.
But I think that there are businesses or wherever you might maybe you can say, Hey, this is where between $10 and $30, the base case of $20, and I have a lot of conviction that it's not worth less than $10. Under almost any conceivable circumstance. We say almost because now obviously, things can happen in the 0.01% probability that maybe it is worth less, right. But I'm talking about the vast majority of the time, let's say 90-95% of the time is not worth less than 10. Well, that's very valuable. Because for that kind of a narrow range of business, I think you have a very hard certainty about the downside.
And you might be okay, demanding a slightly smaller discount to their base case value. So for business like that, it's certainly reasonable to say, Well, I might buy $15, if I think it's worth 20. So that's 75% base case value, because, you know, because there's just not that much I can lose. And by the way, you know, probability of being worth one is not that high to begin with. It's kind of the worst case, right? So that starts to be that tail, the left tail, the probability distribution.
On the other hand, for a business that maybe has a 5 to 50, you know, range of values, right, with a base case of, you know, say you know, $30 or something like that. You don't want to buy the three quarters, of the 30. You don't want to buy the 20 to 50. But the worst case is 5, because you can lose a tonne of money.
That's not a good plan. Right? So I think that a tighter value ranges, and that tightness comes from the business characteristic itself. It comes from business being predictable by it being resilient to adverse change, right. And that's where you have to think and they might ask, Well, how do we know if it's resilient to adverse change? Ah, well, that's the skill. That's the art right? There is the science and the math and all these numbers.
And that's fine. We can put that to one side. But the other part of it is deeply thinking about the nature of the business. And what I'm trying to tell you in this video is that you have to link the nature of the business and the management team combined and the balance sheet those three things to what does that mean in terms of kind of a picture of the likely range and distribution of probabilities of intrinsic values of that business? And then you obviously have to model the situation update that as reality unfold.
Anyway. I mean, I don't have any answers for you as for specific companies, that's your job. But I think that having the mental model of having value ranges and probability distributions and having potential for them to be not symmetrical and having different with in terms of mapping to different business characteristics I think that's a valuable tool in your arsenal to help you think deeper about value and applying intrinsic value process. I hope this video has been helpful to you if it has, please hit like and subscribe to the YouTube channel. And thank you for listening guys.