Don’t Ignore “Base Rates”

Inlägget idag kommer jag ifrån att jag helt ogenerat skrivet av delar ur någonting som jag tycker är läsvärt. Det är från professor Sanjay Bakshi. Bakshi.håller bl.a. i värdeinvesteringskurser i New Delhi. Han har även sitt eget investmentbolag, Tactica Capital, som drivs tillsammans med några av hans ex.studenter.

Texten handlar om att inte bara dra lärdomar från egna erfarenheter utan även från andras, goda som dåliga.Samt att man bör utgå från vad som fungerar för de flesta, inte ett fåtal.

"One of the great lessons from studying history is to do with “base rates”. “Base rate” is a technical term of describing odds in terms of prior probabilities. The base rate of having a drunken-driving accident is higher than those of having accidents in a sober state.

So, what’s the base rate of investing in IPOs? When you buy a stock in an IPO, and if you flip it, you make money if it’s a hot IPO. If it’s not a hot IPO, you lose money. But what’s the base rate – the averaged out experience – the prior probability of the activity of subscribing for IPOs – in the long run?

If you do that calculation, you’ll find that the base rate of IPO investing (in fact, it’s not even investing…it’s speculating) sucks! It’s that’s the case, not just in India, but in every market, in different time periods.

In the same way, what is the base rate of investing in penny stocks?

When you buy those 1 or 2 rupees stocks, some of them will go up to 4, or 5, or 10 bucks…there’s no question about it. But the averaged-out experience of putting money in penny stocks is bad, because most of those companies are junk companies.

When you evaluate whether smoking is good for you or not, if you look at the average experience of 1,000 smokers and compare them with a 1,000 non-smokers, you’ll see what happens.

People don’t do that. They get influenced by individual stories like a smoker who lived till he was 95. Such a smoker will force many people to ignore base rates, and to focus on his story, to fool themselves into believing that smoking can’t be all that bad for them. What is the base rate of investing in leveraged companies in bull markets?

It’s not difficult to know that you’re in a bull market. You pick up the P/E multiple of an economy and compare with the average past P/E multiple and generally look at the prosperity around. It’s not difficult for an investor to figure out that she is in a prosperous environment. Well, the averaged out experience of people buying stocks of highlyleveraged companies in such an environment is bad!

This is what you learn by studying history. You know that the base rate of investing in an airline business sucks. There’s this famous joke about how to become a millionaire. You start with a billion, and then you buy an airline. That applies very well in this business. It applies in so many other businesses.

Take the paper industry as an example. Averaged out returns on capital for paper industry are bad for pretty good reasons. You are selling a commodity. It’s an extremely capital intensive business. There’s a lot of over-capacity. And if you understand microeconomics, you really are a price taker. There’s no pricing power for you. Extreme competition in such an environment is going to cause your returns on capital to be
below what you would want to have.

It’s not hard to figure this out (although I took a while to figure it out myself). Look at the track record of paper companies around the world, and the airline companies around the world, or the IPOs around the world, or the textile companies around the world. Sure, there’ll be exceptions. But we need to focus on the average experience and not the exceptional ones. The metaphor I like to use here is that of a pond. You are the fisherman. If you want to catch a lot of fish, then you must go to a pond where there’s a lot of fish. You don’t want to go to fish in a pond where there’s very little fish. You may be a great fisherman, but unless you go to a pond where there’s a lot of fish, you are not going to find a lot of fish.

The same idea applies to investing. You may be think you are super-skilled in penny stocks, or leveraged stocks in bull markets, or IPOs, or airline stocks, or paper stocks. But that doesn’t matter as much as the idea that fishing in such ponds won’t get you a lot of fish.

On the other hand, the base rate of investing in dominant FMCG companies bought at attractive prices over the long-term is good. It’s very good in the US, in Europe, Australia, Japan, India – it’s good wherever you look. That’s a pond with a lot of fish, which fishermen mustn’t ignore.

So one of the great lessons from studying history is to see what has really worked well and what has turned out to be a disaster – and to learn from both."

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