“One of the advantages of a fellow like Buffett, whom I've worked with all these years, is that he automatically thinks in terms of decision trees and the elementary math of permutations and combinations” -Charlie Munger, The Art of Stockpicking
“Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about”
In this piece on EDCI, I will consolidate the information I have already presented into a decision tree to determine the expected value of this liquidation play and evaluate its merits as an investment operation. I’ll proceed from the moment the $30 million is distributed, leaving my total capital invested in the operation at $10 million.
The first thing to consider in this operation is the tremendous benefit of optionality implicit in this liquidation. As the September 14th filing states: “EDCI is also considering using a portion of the initial distribution of up to $30 million to effect a tender offer in conjunction with the dissolution process. Such an approach would afford additional flexibility to shareholders who prefer a fixed amount of cash and immediate recognition of any tax-losses, to so elect for a portion of their shares.” Thus, right of the bat, the potential investor has a contingency plan in this liquidation that allows him to cash out fairly early at a future determined price. There is not enough info to determine at what price they will tender but its fair to assume it’s above $6, I’ll use $6.40 as a midpoint between the estimated liquidation value and the current market price.
With this piece of information, I can borrow a mental model from Texas Hold’em and begin analyzing this operation from the perspective of a decision tree, where information, future values and risks are embedded in this analysis to arrive at an expected value calculation for EDCI’s liquidation value:
At 6$, I’m calling the blind to see the flop (the October proxy filing that will discuss the liquidation further). Analyzing this new piece of information, the value of my hand will change relative to the new information and I will be faced with several scenarios on how to best proceed.
Scenario 1: I do not like the information, my hand is bad. Fold. As EDCI is trading at ½ cash and book value, I estimate that my downside risk is small, so I settle for a loss. Prior to the announcement, EDCI traded at $5, assume I can exit at midpoint of $5.50 for a loss of $.50.
Scenario 2: The information is neutral and I elect to accept the tender offer of $6.4 for a gain of $.40. Take Down the Pot.
Scenario 3: The information is positive and I elect to maintain my investment. Check to 4th Street. In order to pursue this path, I have to assume that the expected value of continuing in this position will be greater than the $6.40 I could have acquired on the flop (at tender announcement).
At this point, the analysis becomes more complex as I am dealing with time factors, the uncertainty of corporate, economic and financial developments and the cash burn, which threaten to eat away at my return. Depending on my confidence, assessment and judgment, I can either continue the bet or cash out for $6.40, a 6.66% return in roughly 2-3 months (24-36% annual). Assuming I continue the bet, I cash out for the initial $30 Million and have $10 Million in the deal, $1.53 per share.
Returning to my analysis in part 2:
- If the liquidation is finalized in one year:
Liquidation Value: $2.01 ($2.38-$.37)
Expected Annual Return: 31.37%
- If the liquidation is finalized in two years:
Liquidation Value: $1.64 ($2.01-$.37)
Expected Annual Return: 3.5%
Given the scenarios I have outlined, I can now use probabilistic reasoning to derive a mathematical expectation of the investment operation.
Scenario 1: 10% probability = E(V) = -.05 [-.50 * 10%]
Scenario 2: 60% probability = E(V)= .24 [.4 *60%]
Scenario 3a 20% probability= E(V)= .43 [(.48 * 20%)/1.1]
Scenario 3b 10% probability = E(V) = .01 [(.11*10%)/1.1^2]
Mathematical Expectation = -.05+.24+.43+.01= 0.58
This tells me that the operation has positive expectation and that is it worthy of pursuit. I now have to increase the complexity of the analysis as there is an inflexion point, the tender offer, where I can elect to cash out. In order to continue in the position, the expected value of the future payout must be greater than the expected value of the cash out at the time of tender.
My expected profit at the time of tender, the flop, is $0.19, on a $6 dollar investment; this is 3.16% in 2-3 month time horizon for a 12-18% annual return. My expected profit in continuing, on the turn and river, is $0.44; on a now reduced $1.53 investment, for a return of 31.37%. Based on the information that reveals itself, I can adjust my probabilities, expected returns and ultimately, the expected value from this operation.
In essence, I have a positive expected value with the option of continuing in my wager as the situation reveals itself further. As David Sklansky says in his book “The Theory of Poker”: “Any time you make a bet with the best of it, where the odds are in your favor, you have earned something whether you actually win or lose the bet. By the same token, when you make a bet with the worst of it, where the odds are not in your favor, you have lost something, whether you actually win or lose the bet.”
The strategy implicit in this position would be to pay to see the flop, knowing that the investor can cash out at a positive expected value if the information is not his/her liking. He/she can then reassess the scenario as the cards [proxy filing] reveal themselves and reevaluate the position based on new information, knowing that the position has positive mathematical expectation both on the flop [proxy filing] and on future streets [based on the estimation of future information].
My approach in this operation is similar to how Howard Lederer approaches poker hands in Hold’em. Call/raise with high probability cards [roughly 17% of hands] and pay to see the flop. As it is probable that the hand will miss on the flop, the poker pro will usually elect to fold the hand at a minor loss, bet to take the pot down in the present or position himself for the turn and river, subjectively reassessing the probabilities as information reveals itself. That’s how I’m playing this hand.
In sum, this investment operation offers positive expectation based on my subjective estimates, optionality as there are several scenarios where the bet can be paid off and a minimal probability of capital loss. While I cannot control the outcome of this operation, I have the wisdom of David Sklansky as an anchor to guide my thinking and reasoning in the probabilistic arena of Wall Street.
Anyone interested in understanding the probabilistic way of thinking about investments should read Mike Mauboussin’s brilliant piece: “Decision Making for Investors”