Uncertainty & Risk – Huge Difference, Big Rewards

January 19, 2018

Uncertainty & Risk – Huge Difference, Big Rewards

  • The market doesn’t understand the difference between uncertainty and risk. In fact, it doesn’t even understand what risk is.
  • Understanding the difference is all you need when investing.



Introduction

Perhaps the most important thing to understand when investing is the difference between uncertainty and risk.

The market hates both uncertainty and risk but fails to separate the two. Therefore, by understanding the difference and how to find it, you expose yourself to low risk, high return investments.

We’ll go through a few examples to show how much power lies in differentiating the two.

Difference Between Uncertainty & Risk

In the investment world, risk is usually defined as volatility which is completely wrong. Your heart is also volatile but when it stops and flattens out, the situation is risky. Nevertheless, both uncertainty and actual risk impact volatility and this is the main reason why the market can’t differentiate between the two.

Therefore, the first thing to do is to use a more sophisticated measure of risk. Risk should describe the possibility of permanent capital loss or below expected returns on investment. As nobody knows what the stock market will do, focusing on volatility is completely crazy.

So how do you determine the risk a stock carries? Well, look at the earnings a business is delivering and the likelihood that those earnings won’t be as strong in the future. Additionally, some companies have high asset values that provide a margin of safety and limit risk.

On the other hand, uncertainty is something completely different. For example, if analysts can’t decipher whether a company is going to have earnings of $1 or $2 next year, they usually describe it as highly risky. However, if the price is $10, the worst case scenario leads to a healthy price to earnings ratio of 10 while the best case scenario leads to a forward price to earnings ratio of 5. On top of it, if the company reaches $2, the stock price would explode as the valuation would be much higher than 10 due to the growth.

Apple Example

An excellent example of how the market doesn’t differentiate between risk and uncertainty is Apple (NASDAQ: AAPL). In the last 3 years, Apple’s stock price has traded in the range of $90 in April 2016 to the current high around $175.

Figure 1: AAPL’s stock price in the last 3 years. Source: CNN Money.

April 2016 is a clear case of low risk and high uncertainty. The market was worried that AAPL’s growth had stalled and that the new iPhone 7 wouldn’t reach stellar sales. AAPL’s revenue was down 12% but earnings per share were still $1.9 for the first three months of 2016 and the dividend had just been increased. Trailing earnings were around $9 which implied a price to earnings ratio of just 10. At that point in time, the S&P 500 had a price to earnings ratio of 25 and also showed no earnings growth. Therefore, for AAPL to be like the market, its earnings would have had to have fallen to $3.6 per share on a yearly basis. Given AAPL’s strong and loyal customer base, that was highly unlikely. So buying AAPL at $90 was a low risk investment.

However, there was high uncertainty, Carl Icahn had just sold his stake in AAPL, nobody knew what the next iPhone 7 would look like, there was a lot of negative sentiment surrounding the capabilities of AAPL’s CEO.

So on one hand, you had a stable company that didn’t see growth for a year but was constantly producing cash and on the other, you had an uncertain future where the options were a slow and steady decline in revenues or a reversal. Both scenarios would have been excellent for the investor as the low PE ratio lowered the risk while the new iPhone increased the potential upside. Heads, you win a lot, tails you win ok.



Current Market Uncertainty & Risk

Yesterday we discussed some agricultural stocks. Among them there were some relatively cheaply priced companies that have very stable businesses and a below market valuation. My point is that the risk for such companies is very low because demand for food is growing and their business models don’t carry much risk. However, as the market can’t see when food prices will rise, thus there is uncertainty, those stocks trade relatively cheaply in relation to the market.

So the situation is one where if food prices further decline, you get a fair return but if food prices increase, you will get a great return. The timing is also uncertain as the great return can happen tomorrow or 8 years from now, another thing the market hates.

An Example Of Low Uncertainty & High Risk

It’s also important to describe the other side of the equation.

The market seems confident that a recession is highly unlikely at the moment and that economic growth and lower taxes are going to push earnings higher. However, the problem is that a recession is impossible to predict as it always surprises everyone. If it were possible to predict, then it would never happen as we could do something to avoid it.

Figure 2: The recession probability model can only show a recession when it already happened. Source: FRED.

So the market seems certain there will be no recession and therefore is happy to pay a high multiple for stocks. Further, the S&P 500 has been extremely stable and the volatility is at historical lows.

Figure 3: The VIX index. Source: CBOE.

This is what the market loves, high assumed certainty in the economy and low volatility. Its means stocks are perceived as low risk investments and the party continues.

However, if you are a sophisticated investor, you know that risk is a factor of price. The higher the price paid for something, the higher the risk is.

Currently, the price of stocks is extremely high and therefore the risk is also extremely high even if uncertainty is seemingly low. The market’s valuation is double its historical average, above what it was in 1929, and just a bit below what is was in the midst of the dotcom bubble at the end of the 1990s. We all know how that ended, so whomever tells you stocks aren’t extremely risky now is lying to you but also most probably doesn’t understand what risk is.

Figure 4: The S&P 500 cyclically adjusted price to earnings ratio is double the historical average. Source: Multpl.



So investing is simple. You have to avoid high risk situations no matter the certainty levels and look for low or no risk situations with high uncertainty where if the bad happens, you get to a satisfying return while if the good happens, you win a lot.

In 2009 and 2002, there was high uncertainty about what would happen, but you still used your phone, watched television, and ate every day. Therefore, the risk was little for many businesses. In combination with a low price, there was practically no risk of loss when investing. However, most were selling.

Understanding the difference between uncertainty and risk is what will allow you to take advantage of the opportunities that happen more often than you might think.