Tuesday, November 24, 2015

The Thing About Prediction

A recent book titled Superforecasters is making waves in the financial circle as expected. The book proposed that it is possible to predict the future, if a good team was in place, with teammates coming from very varied backgrounds and good training. Coincidentally, there had been a few occasions on this website where we discussed prediction and its ultimate futility. Today, we try to marry these concepts, hopefully coming away with a few key ideas for readers to ponder about.

I believe the first thing to know about prediction is to never trust any. Never trust anyone who claims that he can predict and never trust any prediction to be accurate. The business of investing is not to predict the future. The business of investing is to try earn a high expected return by thinking hard about what could happen. Using historical standards this translates to 8-10% return per year and one needs to do this over very long time frame while minimizing risks of losing money. 

The future, is inherently unpredictable and until it happens, it remains a set of probabilities. Pundits will forever say they can predict the future, but the truth is no one can. When the future happens, they would dig out what they have said in the past and then say, "See! I was right!". That's amateur. In today's post, we hope to get all readers to see past all these.

Let's illustrate with a few examples. Imagine we have a four sided dice and we roll it. For those who have never seen one, take a look at the picture below: these nicely shaped in pyramids with four possible outcomes are four sided dice used in old board games (at least that was the way I used them).

Four sided dice

There are four sides that give four outcomes. We can think of most futures as such, usually there are a few outcomes, one of them will turn out right. So if someone comes and predict the next role will be 4 or 2 (in the dice, it is the number at the bottom) and he turns out to be right, how much credit should he get? The whole world of finance and investing is essentially full of people guessing the next roll, then claiming they knew, they can read the future. Obviously it's not possible. It is only claiming glory in a game of chance after the fact. That's what we meant by "amateur". That's the first point we need to understand. The future is a set of probabilities.

Let's move on to another analogy: now it's four horse race. So now the probability is changing, in the previous dice, all the outcomes have the same 25% probability of occurring. In a horse race, there are champions, and dark horses. Say Horse 1 (Jedi Star) is the favourite, the chances of winning is 50%. Then Horse 2 (War Horse) and 3 (Force Horse) has 20% each and there is the Dark Horse (Dark Side), with only 10% chance of winning. Horse analysts spent careers analysing horses, trying to make predictions. Yes there is some skill involved, but still, luck is pretty dominant. Pundits in the financial world would, by and large, be more like these horse analysts. The skill element while present is elusive. This is very well discussed in a recent book by Michael Mauboussin called The Success Equation.

In some games, skill is very dominant, like baseball or tennis. But in others, skill and luck becomes equally powerful. It is possible for some horse analyst to be able to predict race results or for analysts to predict economic outcome? Yes, there are gurus out there can get some predictions quite right. How right? Well, about 60% of the time. There is still a lot of luck involved. This is the reality. The gurus out there get 6 out of 10 predictions right and 4 out of 10 wrong. Close of half the time, they are wrong. This 60% is the same number that appears over and over again. The best fund managers get 60% of their bets correct. The best basketball players gets 60% of their shots in the basket (or somewhere around the vicinity). Hollywood makes 6 blockbusters and 4 flops.

So, it is not about predicting.

Then what is it about? Well, it is about getting the probabilities right, getting the math of expected return to work, sizing the bet, understanding the reality better, accepting risks and the possible failure ie losing money. It is hardwork, like card counting, or trying your best to make a fun, touching, universally popular movie like the ones Disney Pixar produce. Each movie take years and thousands of man hours. And still, some of them flopped at the box office. In fact, it is very difficult to predict which movie will make it, according to Hollywood insiders.

This is what the game is about. Let's use a real investing example: our favourite shipping liner Neptune Orient Line or NOL in short. It has gone up 50% in the last three months. It was at a 10 year low at 80c and it shot all the way up to $1.2 or so. Some analysts got it right and they say, "See, NOL is worth a lot, now someone is willing to buy at a much higher price vs 80c." Was that foresight?

Let's turn back to clock to say a year ago, i.e. 2014. The shipping industry had boomed and busted primarily because of China. It went from a total shortage of ships to 30-40% over capacity in a span of 6-7 years. At the peak of the capacity shortage, customers all over world scrambled to get shipping lines to send their goods. It cost more than $2,000 to ship a container box (called TEU in the industry) across the globe. Shippers were super bullish, they started building more ships and bigger ships. They argued that the vintage of ships globally were too old. A lot would need to be scrapped. Hence there was a need to increase capacity by a lot.

Then the GFC came, and then China collapsed. These ships, which took 4-5 years to build, came out right at the point where demand was non-existent. Ships had no goods to ship. They decided to go slow steaming i.e. running at half the usual speed, to save fuel and also to reduce capacity. Shipment cost per TEU collapsed.  That was still not enough, they cancelled orders for ships that were built halfway. Then also scrapped all the old ships. Some shippers went bankrupted, even a large one was at risk. But still the over-capacity issue could not be solved.

NOL five year chart

NOL was right in the middle of it all. It was bleeding through the hull and struggling to stay afloat.  It was burning a billion dollars per year for the last few years. Its book value dropped from $1.5 in 2008 to 80c in 2014. They cancelled orders, cut costs to conserve cash and finally sold their logistics business to raise cash. To rub it in, it was rumoured that Temasek decided it would not save NOL after saving it so many times. So this was it. This was the moment of reckoning for our beloved shipping line.

So, what were the future options for NOL? Now we must understand we should not have the benefit of hindsight as we have now. At that point in time, we would need to try to paint the future in a few options. Here's what it might look like:

Option 1: Cut enough to pull through, TEU prices cannot remain below cost forever

Option 2: Raise money from other investors or the market

Option 3: Bankruptcy

Option 4: Find a strategic buyer

There could be more options, but let's put it at four. Next we have to assess the probabilities and also the return potential of each option. Now, since we won't have the luxury of having full time analysts working on these, the no.s would be pretty arbitrary. In a real process, each number would be debated and each return potential calculated and debated and re-calculated. That's real investing and real work. It would take man hours of analysis. Lots of mental workout. Again for simplicity, we would say that the price was 80c while we were doing this. Here's how the future could pan out, at that point in time:

Option 1: 30% probability, book value dropped by another 20%, share price hit 60c (-25% return)

Option 2: 40% probability, equity raised with 30% dilution, share price hit 50c (-37% return)

Option 3: 10% probability, bankruptcy, share price goes to zero (-100% return)

Option 4: 20% probability, strategic buyer buys it over at a slight premium, share price hit $1.2 (50% return)

So, working with these probabilities and return numbers, it would be clear that NOL had very poor expected return. It would be a negative 22% based on the above probabilities. In fact, we could play around with all the probabilities (and/or returns) and realized that most permutations gave poor expected returns except when we ascribed a 60% or higher probability that a strategic buyer buys it over.

So for those analysts who said they got it right, was it foresight? Or luck? Or something else? For the un-initiated, a rumoured bidding war between two strategic buyers came out for NOL which is why the stock is now up 50% from September. This was one of the future options that panned out. But it could well have been bankruptcy or more likely equity raising in the market with Temasek not supporting it. The future was always just a set of probabilities, what turned out to be the reality/future doesn't mean it should be. No one could have read the future.

As it stands now, it is still unclear how far have the negotiations moved. All bets could still be off because it is ultimately not very beneficial to buy over NOL. What could NOL provide that Maersk or CMA couldn't get? It doesn't need more ships nor crew nor customers (they have the same customers). It would just be a case of buying NOL over to shut it down so that there is one less competitor to disrupt prices. Does it make sense? Or would the buyer try to strike a deal with Temasek and Singapore to get preferential treatment at PSA terminals globally? Or what? It was not clear.

Hence it wouldn't be easy to ascribe a high probability that a strategic buyer would bail out the current NOL shareholders. But as it turned out, this is what caused the share to skyrocket. There would be pundits who would want to claim credit. But as astute investors, we should know better.

The thing about prediction is that it is not what we think it should be like following pundits and it is actually a lot of hard work thinking through everything. The term Superforecaster might well be a misnomer. Well, as Singaporeans, we still hope NOL gets saved though. Happy Thanksgiving! Cheers!