The Misperception Of False Precision For Price Targets And Probabilities

“Objectivity is gained by making assumptions explicit so that they may be examined and challenged, not by vain efforts to eliminate them from analysis.”
– Richards Heuer, Psychology of Intelligence Analysis.

Some investors chafe at price targets because they smack of “false precision.”  These investors are missing the point because the key to price targets is not their absolute validity, but their explicit nature which allows for objective conversation about the assumptions that went into them.  Said another way, price targets improve the investment process because they foster great questions and force the team to be able to defend the methodology behind their calculations.

If “false precision” is the concern, then probabilities are doubly damned. They not only require precise estimation, but are considerably more subjective than price targets. The problem with this argument is that probability is an assumption in the process even if you don’t make it explicit. No investor believes they’re 100% right, so there is always a chance of success and failure. In an implicit process, probabilities are expressed with words like “pretty confident” or “high likelihood”, but they are still an estimate of probability. One that is easily misunderstood and difficult to judge. For the same reason that you should require explicit price targets, you should require explicit probabilities.

Not only do explicit price targets and probabilities help investors make better decisions in the short term, they also allow firms to use historical analytics to measure where they are making mistakes and find ways to avoid them.  Great PM’s should be able to leverage information like:  My analysts assume they’ll be right 74% of the time but are actually only right 51% of the time. I will just ask them to adjust their assumptions accordingly.

To make the differences more concrete, I’ve created an example conversation. Problems are better framed when price targets and probabilities are explicitly defined. Compare these conversations and choose the one that you’d prefer as a portfolio manager (I’ve bolded the differences in the two pitches):

Implicit: I think we should add Baidu to the portfolio because overall earnings are being depressed because their non-search business lines are losing money. The current search business is solid, as Baidu holds a natural monopoly in China like Google does in the U.S.A. and their prospects are even better because their users are rapidly moving from 3G to 4G mobile, which will dramatically increase search demand. Their two money-losing lines are independently worth $10+ billion, but are currently not assigned value. The risk is that they can’t monetize the two non-search businesses and they become big money losers. I think there is a high likelihood this is double based on the sum-of-the-parts over the next year or so and has limited downside based on net cash and conservative earnings and multiple. The Risk-Reward is compelling.

Explicit: I think we should add Baidu to the portfolio because overall earnings are being depressed because their non-search business lines are losing money. The current search business is solid, as Baidu holds a natural monopoly in China like Google does in the U.S.A. and their prospects are even better because their users are rapidly moving from 3G to 4G mobile, which will dramatically increase search demand. Their two money-losing lines are independently worth $10+ billion but are currently not assigned value. The risk is that they can’t monetize the two non-search businesses and they become big money losers. I think there is a 70% chance the stock could hit $350 based on sum-of-the-parts over the next year and has downside to $150 based on net cash and conservative earnings and multiple. The Probability-Weighted Return is 50%.

Your discretion as a portfolio manager is not lessened by explicit assumptions. In fact, the explicit assumptions are examined and challenged in a way that is not allowed by the vagaries of implicit assumptions. What “high likelihood” means to you may be different than your analyst. Your interpretation of “limited downside” may be different. Explicit assumptions aren’t designed to make you guess at the unknowable. They are designed to make sure the investment case can withstand the stress of being explicitly defined. If they can’t, you are investing at your own peril.

This post is an extension of the 2014 post – Explicit Lyrics – Why Implicit Assumptions Are Dangerous.