Dr Ajibola Awolowo
The last few years brought sky high valuations to the equity markets in the United States. We saw the S&P 500 and the NASDAQ attain new heights after new heights. Many companies traded at ridiculous price to earnings ratio. It really did look like this time, it was indeed different.
This has now changed over the last few weeks. We have seen crimson blood flow in the streets. Low price levels not seen for over a decade have been reached. The dip has dug deeper. The question that now lingers in the hearts of many investors is, how low can prices go?
What has changed? Why has the roar of optimism been silenced at the realisation that we are at the cusp of monumental pessimism? I dare say nothing much has changed. The only shift we are making is how we balance the scales between projection versus protection. Let me explain:
The market operates in cycles. In the bullish cycle, the economy flourishes, companies grow tremendously and financial statements print huge profits. This gets investors and investment professionals all excited. We all feel the good times are here to stay. We bring out our calculators, fire up our Excel spreadsheets and start our discounted cash flow analysis to arrive at the intrinsic value of various assets.
We look at the presently high growth rates, low risk-free rates (this usually correlates with periods of bull runs in the stock market) and Project this growth into perpetuity. Our models churn out prices that justify our purchase of companies at a Price to earnings ratio of over 50 (Teslas’ P/E ratio was over 1,000 at its peak and it still got many buy ratings). Our friends, family, investment Twitter, investing forums and investment houses issue buy ratings on these companies as well. This confirmation bias pushes us to buy more as prices rise further.
Suddenly the tides change. Something shifts in the macroeconomic environment or a core assumption about the company changes and we recognise that our lofty Projections were unrealistic. Everyone scrambles for the door hoping to Protect their capital. We all sell our stocks which trigger a large plummet in prices.
It all becomes doom and gloom. The Bear is in town and we need to take cover. The DCF and Dividend discount model spreadsheets are once again fired up. Modest growth rates are now further heavily discounted. Premium risk-free rates are now used as no one wants to take risks with their capital anymore. The emphasis shifts to protection of one’s capital at all costs.
Each time, the triggers may be different, just as the assets involved can range broadly from Tulip flowers to a unique scribble or digital art (just google cryptopunk or Ape yatch club) but the cycles are always the same. Nothing is ever different. History may not repeat itself but it certainly does rhyme. At every point in time, we are at some point along the balance between Projection of the good times and protection from the bad times.
When we solely Project, we assume that growth or profitability continues unchallenged. A company being a clear market leader today and growing at 30% annually over the last 5 years does not mean it will sustain this position or growth over the next 5 years. We must realise that every company is one decision away from a crisis. We expose ourselves to untold risk when we only Project.
On the other hand, being overly Protective makes us risk averse. It makes us sit in treasury bills, government bonds or cash whose yields are below the inflation rate thereby destroying our capital. Our natural human instinct is to stop pain as soon as we can. Unfortunately, we fail to realise, in the moment, that nothing great was born without some pain (just ask any parent).
If blind projection or protection can lead to permanent loss of capital, what then do I recommend you do as an investor?
First, you must have a mind of your own. Realise that you do not need to follow the market consensus. The crowd is correct most of the time but not all the time. When everyone is projecting (being optimistic about future growth/ profits), that might be the best time for you to ask yourself if seeking protection (recognise the downsides and identify ways the crowd may be wrong) is the right thing to do and vice versa.
You cannot beat the market by being the market. Being contrarian means accepting the unpopular and being lonely. Years of evolution has programmed us to seek safety in consensus. The buffalo that goes alone tends to get eaten by the lions. Don’t be contrarian just for the fun of it. The contrarian road crosser gets killed by a bus. The decision to veer away from the crowd must be backed by data and sound reasoning.
Secondly, while situations where we need to solely project or protect do exist, they are rare and only come at market extremes. It therefore might be wiser to combine these two strategies in practice.
I do this by trying very hard to shoot down my own ideas. When I find a new company that I really like, I always ask, “How could I be wrong?” or “Under what circumstances will my thesis fail to pan out?” If I cannot put any holes in my analysis, I seek the opinion of other investors I respect. They might see something or have come across some information that I haven’t which can change my thesis and save me from losing my capital or time.
A recent example that comes to mind is a manufacturing company on the Nigerian Exchange that I really liked. It was growing steadily, operated in a near monopoly and traded at very attractive valuations. The only problem was the company being relatively illiquid. This had been the case over the last five years and did not look like it would change anytime soon. I ignored this illiquidity and put a good chunk of my portfolio in it. I was projecting without doing very much of protecting.
It turned out that the illiquidity was the bane of that company. Thankfully, I was able to exit and move on when a spike in liquidity was driven by some corporate action in the company. I failed to build in enough protection about the illiquidity of this company while projecting about its growth. In the end, I lost time and missed some opportunities while my capital was tied down.
There will always be some negatives or downsides to any investment opportunity. Protecting your capital means that you take a cursory look them all and assess the probability of them materializing. We can never know the future but thinking in terms of probabilities allows us to know which is most likely to occur and to account for it in our thesis. This helps us invest in the safest opportunities that have the highest growth potential.
Every time you catch yourself being attracted to that company that is rising rapidly in price or to that penny stock with the potential to double in price, never forget to ask yourself if you are only projecting without considering the protection of your capital. Doing this sincerely will mean you will miss out on some opportunities. See this potentially missed profits as insurance against the devastating loss you will suffer if the risk materialises.
Your batting averages (percentage of times your decisions are right versus times when you get it wrong) will significantly improve if you only take a swing at opportunities with adequate downside protection.
In conclusion, I’ll share a quote from Confucius, the Chinese philosopher. “By three methods we may learn wisdom: First, by reflection, which is the noblest; Second, by imitation, which is the easiest; and third by experience, which is the bitterest”.
I have learnt my own lessons about projection and protection from reflecting on my own experience and that of others. I hope you learn yours by reflecting on this article but if you deem personal experience to be the best teacher, good speed!
Dr. Ajibola Awolowo can be reached via this email: valuenigeriawithajibola@yahoo.com