What sets the smartest investors apart from the rest? More often than not it comes down to consistently superior decision making in ‘uncertain’ conditions.
Any effort in coping with uncertainty must define, recognise and understand its different dimensions. McKinsey & Co. have developed a four-level format to identify the spectrum of possibilities. At Stage 1, the future is relatively clear and dealing effectively with a single uncertain variable is adequate. Stage 2 needs the ability to cope with several different views of the future but the alternatives are limited, discrete and fairly easily defined.
Stage 3 is where the level of uncertainty is complicated by the fact that a large number of dynamic interrelated variables come into play. Finally, Stage 4 is about a truly ambiguous environment that requires constant learning and great agility, as investors can never adequately anticipate enough of the future in advance.
While dealing with a Stage 1 situation, it is vital to make an accurate assessment of just how much you really know. Once you get to terms with the limits of what’s known, the best way forward is to estimate a range for the unknown outcome and identify the level of confidence one has with the given range as opposed to the false comfort of a single-point forecast. The knowledge that there is a 75 percent chance of Sensex EPS in FY12 being in a range of 1,170-1,280, is far more useful than a number such as 1,240 which has a 10 percent chance of being right.
Stage 2 demands that one generates multiple views of the future by recognising the inherent uncertainty rather than seek a single ‘most certain’ outcome. The time tested technique of ‘pro versus con’ reasoning is effective since it typically leads to a balanced view. Equally interesting is ‘back to the future’ reasoning. In effect, you need to harness your ability to explain events in hindsight to enhance your skill in anticipating what lies ahead — or oxymorons being permitted, prospective hindsight. The impact of such intellectual time travel is usually greatest in coping with decisions involving large stakes!
Stage 3 events are difficult to tackle given the incredible complexity at work. Scenario planning — a disciplined method for envisioning a range of plausible future outcomes — is by far the most widely used analytical technique. It is a mistaken belief that more information will always lead to better decisions. In fact, additional information inputs are of value only to the extent that they help to ‘see’ the jigsaw with greater clarity. Beware of the genuine risk that increased information will lead to a misplaced rise in confidence with no corresponding impact on the accuracy of the decision.
So where does that leave us given the nuclear fallout possible in Japan, the turmoil in the Middle East, the debt mess in Europe, the improvement (?) in US employment and manufacturing data, a raw material related margin squeeze about to hit corporate profit margins, high domestic inflation and
the continuing QE2 (second ‘quantitative easing’) saga?
The solitary beacon of hope is SRF (Rs. 321), a business with robust cash flows, sensible management, a strong and defensible competitive position that trades at a PE of four times current earnings and offers close to 5 percent dividend yield! Maybe Samuel Butler had a profound take on investing when saying: “Life is the art of drawing sufficient conclusions from insufficient premises”.
Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author, a partner at Fortuna Capital, frequently invests in the shares discussed by him.