Uncertainty and Valuation

Uncertainty has increased due to the crisis. I read a great article by Aswath Damodaran. In it he touches on the behavioral and quantitative aspects of post CoVid Valuation. What’s more as I thought about uncertainty I was reminded of Nicholas Nassim Taleb and Howard Marks. The end result is this post.

For those who haven’t come across Aswath Damodaran then I highly recommend him. He is a true “community” player – he has made his NYU course available to the public and his website has a whole host of resources. The idea of creating a similar resource library specific to high yield is something I hope we can achieve with European High Yield Online.

“Many analysts who use multiples to find under and over priced stocks do so because they do not want to confront the uncertainty associated with forecasting future growth, margins and cash flows in intrinsic valuation.” ―  Aswath Damodaran , A Viral Market Update VII: Mayhem with Multiples

In the chart below he explains why using pricing as a heuristic to derive value is difficult.

Marks and Taleb – embracing uncertainty

Howard Marks is another favourite commentator of mine:

“There’s a big difference between probability and outcome. Probable things fail to happen—and improbable things happen—all the time.” That’s one of the most important things you can know about investment risk.” ― Howard Marks, The Most Important Thing: Uncommon Sense for the Thoughtful Investor

 

On realising expected value: 

 

“…that sounds like a totally rational thing. But what if the course of action you are considering has some outcomes you absolutely can’t withstand? Then you may not do it. You may not do the highest expected value course of action, because it has some [outcomes] you cant live with..Who here is willing to be the skydiver who was right 98% of the time?” ― Howard Marks, “The Most Important Thing – Origins and Inspirations” | Talks at Google

As is NNT:

On the pandemic: “It was not a Black Swan, it was a white swan..The system favours the companies that spend their cash rather than keep it in reserve, spend their cash to buy their stock, and further more borrow over those who were cautious..We should bail out employees, bail out citizens not corporations who have made this mistakes.”  ― Bloomberg Markets and Finance – Nassim Taleb Says ‘White Swan’ Coronavirus Pandemic Was Preventable

With High Yield upside return is capped and the downside is 100%. In exchange we accept better recovery prospects and security over assets. Perhaps capital requirements will be coming to a corporate near you, perhaps even limitations on leverage. Focus on the downside, the loss. At its’ core highyield is a skeptics asset class, now, more than ever.

As I touched on in the “New Normal” a decline in revenues can have an exponential effect on earnings, Government support means that survival for most is guaranteed near term. Investors appear to be willing to lend to companies in exchange for security. In some cases the lending fits the criteria of “Ponzi Bonds”.  At the same time default rates are ticking up.

How to think about the future? Well – as a range of possibilities.

The range of possible outcomes for company earnings has increased significantly.

I do not think “relative value” ,comparing companies in the same industry or credit rating makes sense now. Even comparing value across the same capital structure is difficult. “It is cheap to the loans” or “its cheap relative to the unsecured” . Really? What is that security worth, what does that earnings stream look like? Relative value in high yield, given its’ heterogeneity, is difficult at the best of times.

Damodaran suggests that the best thing to do is not shy away from making assumptions. Establish a framework and then critique the assumptions. Given the current environment, they will be extreme. That does not make them wrong or right. But it should allow you to establish whether the possible outcomes include those you cannot withstand. High Yield is the sykdiver who has been right 97.1% of the time. 2.9% is the average long term default rate for high yield.

Taleb was asked whether “now” is the right time for investors to buy catastrophe insurance.  His answer was you do not drive a car or buy a house without insurance. So, then, you cannot “time” insurance. Prudence is to be practiced. Marks talks in terms of margins for error. He points out the margin of error increases as prices decline. Given the return distribution for bonds this makes even more sense. Paranoia pays.

How do you build in your margin for error when modelling a high yield company’s financials? I think you have to seek out the scenarios that cause a company to default and judge how likely they are to happen. Those scenarios could involve a second shutdown, reduced capacity borrow at a super senior level a second time round and reduced future government support. It may seem outlandish, but putting it down on paper will give you an idea how large a white swan it is,

Distressed companies, will offer a higher margin for error relative to future mark to market. Well rated,capitalized, high yield companies will survive. Governments will be buying fallen angels.The belly is of the credit distribution is where the pain will be felt. Picking the credits with outcomes you can withstand is key. Predicting that range of outcomes is impossible, assuming the worst is not.

What do you think?

• I would like to know who and where your inspiration comes from when thinking about risk, investing and high yield.
• Who inspires you?
• What is the best advice you have been given?
• How do you think about uncertainty?
• let me know via the comments section in the blog or email [email protected]