William Osler was a Canadian physician and one of the four founding professors of Johns Hopkins Hospital in Baltimore. He created the first residency program for specialty training of physicians, and he was the first to take medical students on rounds to see clinical care in practice. He has frequently been described as the "Father of Modern Medicine."
Osler spend a great deal of time thinking about risk and probability given the rate of infection and deaths related to early 20th-century clinical care. He recognized Western medicine was still in its infancy, and our understanding of the human body was still in its early stages. He was intrigued by the difference between risk (potential options which represent a danger to his patients) and probability (the odds of a risk developing in his patients). One of his more famous quotes was:
“Medicine is a science of uncertainty and an art of probability”.
Risk and uncertainty: Two different animals
Osler’s statement has a great deal of applicability to the greater investment community. In value investing the great challenge is making the distinction between risk and uncertainty. At Nintai we spend an inordinate amount of time contemplating these two concepts. For many these are one and the same. However, the difference between the two is profound. The inability to make the distinction can lead to catastrophic losses that are sometimes impossible to recover from over the long term.
We think Michael Mauboussin described it best in his extraordinary book "More Than You Know: Finding Financial Wisdom in Unconventional Places". He wrote[1]:
"Risk has an unknown outcome, but we know what the underlying outcome distribution looks like. Uncertainty also implies an unknown outcome, but we don’t know what the underlying distribution looks like. So games of chance like roulette or blackjack are risky, while the outcome of a war is uncertain. Knight said that objective probability is the basis for risk, while subjective probability underlies uncertainty".
Another description that I think is worthwhile is from Nate Silver's excellent book "The Signal and the Noise". He writes[2]:
"Risk, as first articulated by the economist Frank H. Knight in 1921, is something that you can put a price on. Say that you’ll win a poker hand unless your opponent draws to an inside straight: the chances of that happening are exactly 1 chance in 11. This is risk. It is not pleasant when you take a “bad beat” in poker, but at least you know the odds of it and can account for it ahead of time. In the long run, you’ll make a profit from your opponents making desperate draws with insufficient odds. Uncertainty, on the other hand, is risk that is hard to measure. You might have some vague awareness of the demons lurking out there. You might even be acutely concerned about them. But you have no real idea how many of them there are or when they might strike. Your back-of-the-envelope estimate might be off by a factor of 100 or by a factor of 1,000; there is no good way to know. This is uncertainty. Risk greases the wheels of a free-market economy; uncertainty grinds them to a halt."
Price, value, uncertainty and risk: Equalization at work
By looking at a stock through the lens of risk (a certain number of defined and measurable possibilities) and uncertainties (defined and immeasurable possibilities), we think investors can avoid making some tremendous unforced errors. While this is vital, we believe this represents only half the equation.
When considering risk and uncertainty we propose that price and value are the great equalizers. Howard Marks (Trades, Portfolio) once wrote, “No asset class or investment has the birthright of a high [or low] return. It’s only attractive if it’s priced right[3]”. Stocks with an enormous amount of uncertainty can be considered a reasonable investment opportunity if the price is sufficiently below intrinsic value. Conversely a company with very little uncertainty can be extraordinarily risky if purchased significantly above fair value. When thinking about these two factors, it is essential investors always place them in the context of value and price.
A tale of two stocks
At Nintai we have two stocks on our watch list – SolarWinds (SWI, Financial) and Meridian Bioscience (VIVO, Financial). We’ve discussed SolarWinds previously. One of the measures we use to evaluate each stock is how it rates by both risk and uncertainty. The following is a sample report from Abacus we ran on both companies with a few select fields:
Scale is 1-10. The higher the score the greater value in investment opportunity.
As you can see the companies differ on several areas such as risks associated with pricing and competition. In each we have relatively clear appreciation for the number of competitors, their strength, and the odds of capturing market share. In addition we have insight into pricing, unit costs and profit margins. In each case we can develop an informed model based on the respective risks.
An uncertainty is the chance of government regulatory action in their respective markets. In this instance we have an idea of the risk but no idea of the odds of any action. We believe it is extraordinarily small for SolarWinds but much greater for Meridian as they provide their product in a highly regulated industry. In this case it is difficult – perhaps impossible – to assign a probability of the chosen risk happening.
While this exercise is helpful in itself, the real value comes in matching risk and uncertainty to price. The fundamental question we are looking to answer is whether either company’s stock is worth the allocation of capital in light of the risks and uncertainties? Without going into all the details we use several key data points to help us make that decision. These include estimated intrinsic value, price, risks and uncertainties. In the case of SolarWinds we believe the stock is worth roughly $33/share with a current price of $48.65 (as of March 17th, 2015) and is currently trading at roughly a 48% premium to fair value. With an average RU (Risk/Uncertainty) score of 5.3 (on a 1-10 scale with 1 most risky and 10 least risky) we don’t believe it’s prudent to overpay for a stock of average risk and uncertainty. Running the same evaluation for Meridian we place an estimated fair value of $16/share with a current price (as of March 17, 2015) of $19.67 or a 23% premium. With an average RU value of 8.1 this stock is slightly more interesting but would likely remain on the watch list until a better price point appears. In this exercise we can see the difference in the RU can be quite different (a variance of 2.8 points) but price and value tell us that both companies are not worth a current investment.
Conclusions
Risk and uncertainty are key components in understanding any potential investment opportunity. It is critical to make a distinction between the two and understand the impact of both. Even more important is the ability to place these two factors in the context of price and value. Only when this is completed can we truly ascertain whether we can obtain an adequate margin of safety. Much like Dr. Osler said there is both an art and science in valuing a potential investment. The ability to combine both is the earmark of a successful value investor.
As always we look forward to your thoughts and comments.
[1] Michael Mauboussin, “More Than You Know: Finding Financial Wisdom in Unconventional Places, page 36
[2] Nate Silver, “The Signal and the Noise”, page 112
[3] Howard Marks (Trades, Portfolio), “The Most Important Thing”, Chapter 4, page 1
