Hope is Public Enemy Number One: An Extension of the Margin of Safety Discussion

Hope is a wonderful thing. It allows us to dream of a brighter future. Without hope, all of humanity would exist in a perpetual state of depression. A life without hope would not be worth living.

But hope, for all of its good qualities, is enemy number 1 of the prudent investor.

Hope causes us to believe a situation will improve without a reasonable basis in fact. Let's suppose, for example, we are analyzing a company that has experienced a 25% decrease in annual earnings from its all-time high. Hope causes us to shortcut the analysis by blindly making the assumption that earnings will eventually rebound to the previous highs. If we make the decision to purchase shares based solely on that assumption we become slaves to hope. We run the risk of not making money, or worse, losing money, if earnings do not recover. The only escape is to be hopeful of a brighter future.

It is certainly possible for a company to have a large drop in earnings followed by an equally large increase in earnings. But that is beside the point. The problem arises when the investor's expected return is entirely dependent upon the eventual rise in earnings. If earnings do not rise he loses money, either in absolute terms or in opportunity cost. What he needs is a backstop, i.e. a margin of safety. He has to ignore the hopeful desire for earnings to increase and only purchase shares if he can reasonably expect to realize an adequate return even if the situation doesn't improve.

When analyzing stocks, you should look for situations where you have a high probability of profit even if things do not improve for the company. In other words, buy stocks at a low enough price that even if earnings do not grow you have a good chance of price appreciation and if earnings decrease further you won't lose too much (Mohnish Pabrai calls this "heads I win, tails I don't lose too much"). Do your analysis, and make your decisions, based on reasonable case and worst case scenarios. Ignore the best case because it is the result of hope. If your expected return is not dependent on the best case scenario, but it subsequently materializes, so much the better. You exceeded your expected return. The best case scenario is nothing more than a free option to the prudent investor. GRAVY!