Dr Ajibola Awolowo
The folktale is told about an individual who looked at the dark clouds in the sky, observed the fast gales of the wind, heard the thunder rumble and discerned that it was going to rain. He went ahead to empty all his reservoir of water saying it was dirty in anticipation of collecting clean water in its place from the impending rain. Unfortunately, the clouds dissipated, the wind settled and the thunder quietened. The rain failed to fall and he ended up having no water in the house.
Just as the individual in the folktale above learnt, howbeit, painfully, placing large bets based on your assumed certainty of a particular future outcome can be disastrous especially when one does not have a backup or risk management plan in place. If there is one thing we can certainly say about the future, it is that the future is uncertain.
At the start of every New Year, economists use the trend of fiscal policies, macroeconomic indicators, crude oil prices amongst other things to make predictions about the economy in New Year. A few predictions are correct. Many others are widely off the mark. Those who were right with their predictions this year are often time wrong the following year. This leads me to conclude that correctly predicting the future consistently is a skill that eludes men.
In 2017, the Nigerian Gross Domestic Product (GDP) grew by 0.8%. It grew by 1.9% in 2018 and got further bolstered by an impressive 2.2% in 2019. Looking at the trend, one can easily conclude that year 2020 would bring further growth in GDP. In fact, President Mohammadu Buhari in his 2020 budget speech projected a GDP growth of 2.9% for the year 2020.
In reality, the Nigerian GDP contracted by 1.79% and 2020 ushered the nation into a recession. Almost no one could predict the impact that COVID would have on the global economy. Having global lock downs was something unprecedented but it happened. We can argue that that was a black swan event but the fact that an unforeseen event could derail the projections of the global economy gives credence to the fact that the future is inherently unpredictable.
If the President and his economic team/ advisers using all the resources and data available to them could not correctly forecast the future, then maybe it is futile for us to attempt doing this as well.
Even though the path to forecasting the future is treacherous and lined with the dried carcass of those who have failed in their attempt, predicting the future is exactly what we try to do in investing. We buy a company because we feel that, in future, it will be worth much more than the price we pay for it today. When we decide to sell a company, it is mostly because we think its future price will be lower than the price we are selling it for today.
How then as investors can we tame the untameable? How can we safeguard ourselves against the challenges that uncertainty brings? This is the dilemma that investors have faced, are facing today and will continue facing into the future. I will share a few thoughts on how to choose which companies to buy and structure your portfolio in a way that ensures your profitability and longevity in the face of certain uncertainty.
Have a proven process for company selection:
Rather than letting the ‘Fear of missing out’ or emotions dictate which companies you buy, I encourage you have a structured, detailed and documented process of selecting companies that enter your portfolio.
When you choose companies based on sustainable and near-predictable metrics such as consistent and growing free cash flows, you put yourself at an advantage over other investors who buy based on fickle and unsustainable reasons such as recent increase in price or a friends/ guru’s recommendation.
When uncertain times come, companies that were bought using process-based decision making are more than likely to do better than those bought on a whim.
Only buy companies that have a proven track record of excellent performance:
The stock market is a melting pot for the good, the bad and the ugly of publicly listed companies. Some of those companies have good history of increasing revenues, profits and dividend payments. Others have a reputation for being average or underperformance.
When a black swan event or economic downturn occurs due to the fickle and unpredictable nature of the future, which of the above groups of companies do you think will weather the storm better? Many years of data and history proves that an excellent company with a proven track record sails through uncertain times mostly unscathed. The same cannot be said about companies with poor history.
Extreme concentration is dangerous:
Even though I personally advocate concentration and discourage over-diversification, I recognise that too much of everything can be bad. Depending on how large your capital is, holding 5 to 10 well researched and understood companies should be adequate. Owning more than 20 companies might be dangerous due to the time needed to keep on top of each of them.
Extreme concentration is putting all one’s eggs in one or two baskets. It seems like a wise decision when prices go up but it’s a terrible when they decline. Thinking that prices will always go up is equal to assuming it is going to rain just because the clouds are grey and the wind is howling. Absolutely nothing is certain as history has proven to us over and over again.
Buy aggressively at the times when the odds are in your favour:
There are occasions when the market is pessimistic and prices are markedly depressed. At times like these, the herd is in a rush to dump their equities for one reason or the other. The crowd suddenly believes that the future is uncertain and that future is not good for the stock market. These are the times when discerning investors must remember that as dark as the night may seem, the odds of the sun rising in the morning are very high. Periods such as this provide rare buy opportunities that we all must learn to take advantage of.
As investors, we must never forget that good times never last forever. Neither do the bad times. We need to exercise caution when the going is exceptionally good as the uncertainty of the future indicates that the tides may change unannounced.
An unusually low price to earnings ratio, low price to book value ratio and low present price as compared to the intrinsic value may all be pointers that the odds of making a profit may be in our favour. They may also be value traps that we must be conscious of and avoid.
The ability/ knack to foresee the future is one every investor tries to put to use irrespective of their investment philosophy and school of thought. I encourage you to stick to a method that increases your odds of making a profit.
When you are right with your forecast, you potentially make a lot of money. When you miss the mark, learning to place your bets in such a way that you do not lose too much money is very essential. The key word in this is “WHEN” and not “IF”. This is because even when you do it right, your forecasts will only ever be proved right 2/3rd of the time. Ensuring you live to fight another day cannot be over emphasized.
In all your investing decisions, never forget that the uncertainty of the future is the only certainty we can count on.
Dr Ajibola Awolowo can be reached via: email@example.com