There is absolutely no evidence that reggae musician Peter Tosh was an equities enthusiast. Yet it is not impossible that he gave the subject some thought. This idea formed serendipitously after an event that occurred outside of my Invest-Notes bubble when I became re-acquaintance with the title cut from Tosh’s 1979 album, Mystic Man, which I have not heard in many years. Don’t laugh, think about it:
- I’m a man of the past
- And I’m living in the present
- And I’m walking in the future
Okay, now a quick primer on investment strategies, made without judgment (it was Ned Davis, after all, who pointed out that it isn’t the strategy that matters, but the discipline to consistently implement one). The past would be folks like chartists, people who look to past performance, and the way equities have responded previously in similar situations, to create a context for future performance.
The present would be bottom-up analysts – a hedge fund type of thing – where painfully in-depth reviews of K-1’s, financial statements and engagement with current management are combined with analysis of industry performance and sales/distribution channel measurements; in other words, a laser focus on the here and now. Yet regardless of where you land within this spectrum, everyone is trying to figure out how to plan for the future.
So, while listening to Peter Tosh I was reading the third installment of the annual Barron’s investment roundtable when this line from one of the participants glowed on the page, “We expect it to trade for 20 times our 2018 estimate of $6.50 a share; the fiscal year ends Oct. 1. That implies 20% upside. The downside is $100 a share, or maybe $95.” A quick comparison of the 2016 results of this same group revealed the only person who did not have a money-losing investment idea was the owner of this quote. It was notable how few other recommendations even mentioned a downside; let alone what it might be.
The case was made for what could cause this stock to see an increase in earnings, an increase in its valuation (the price-to-earnings ratio) and what potential benefit accrues if these assumptions are correct. This is the standard narrative; why a stock is going up, and how much you could make. What caught my attention was the reasoning behind the downside projection. A well-run company, with a long history of delivering shareholder value (a consistently profitable enterprise through many economic environments) that does not face any obvious headwinds. In other words, in the event of an overly optimistic scenario for the future, the stock should muddle through – and remain profitable while delivering a consistently increasing dividend.
A review of some of the other Barron’s roundtable picks from 2016 showed several companies where the upside was expected to come from major surgery, which either didn’t occur, or after which the patient did not improve and often got worse. In retrospect, this feels more like speculating than investing. The chance and magnitude of potential loss matters, a lot.
The lesson here is to first understand the downside risk, which is more important than creating a dreamy view of an unknown future. As Warren Buffett has suggested, you don’t buy companies with problems to fix but businesses doing just fine that have opportunities for improvement. And just maybe, by starting with a view of past performance, then comparing and contrasting the most current performance and financial information is the most reasonable way to step comfortably into the future when looking at individual equities.