Uncertainty Rating – What is it?

A recent article by Pat Dorsey on Morningstar raised my interest the other day. Morningstar has come up with an additional valuation rating when providing the fair value for companies; the uncertainty factor. Since the future can never be accurately predicted and is only an assumption, a level of uncertainty always exists with any valuation.

Non Linear Future

The future has a countless number of possibilities ocurring. There doesn’t seem to be any trend or predictability that we can rely on. With so much unreliability and uncertainty in the future, it is surprising that we calculate a single intrinsic value which then forces us to focus on one possible outcome. We end up with an intrinsic value that only considers one type of outcome. But what about the millions of other outcomes? Is it worth considering?

Uncertainty

Well, it’s too hard to try and calculate every range of intrinsic value based on current situations but if an uncertainty rating was also applied in tandem with the intrinsic value, it may result in a wiser decision. It may help us to see that some “value stocks” are actually too “uncertain” to bet on. It’s like betting without knowing the odds. You may think you have good odds, but you aren’t certain.

In the current financial market, most of the companies have dropped in value by around 50%. This may seem like a good reason to pick up a few financial companies, and although uncertainty is the friend of the investor, uncertainty + impending trouble or another combination is NOT the friend of the investor.

E.g. Although Merrill Lynch seems to a cheap buy, down 50% from its highs, it remains to be seen how the subprime market will be resolved and how the company plans to go about with the huge subprime writedowns. Companies with problems, in an industry with problems is quite a dangerous concoction. Compare the uncertainty factor for, say Merill Lynch to another stabler company with a similar value and it’s pretty evident which company is the better one to invest in – the more predictable/stable company.

How it Applies to Old School Value

The intrinsic value spreadsheet and Graham formula spreadsheet both are based on past years to create a linear progression for the future, but trying to predict the future by just looking forward is simply wild and crazy.

In the business world, the rearview mirror is always clearer than the windshield. – Warren Buffett

As I stated above, the future is definitely non-linear and that is one of the limitations with the spreadsheets. The spreadsheets only provide a single intrinsic value by assuming that growth is linearly increasing. However, we know growth can and has been negative depending on economic situations. And that is why I believe Morningstar has started to implement the uncertainty factor.

However, our Old School style has already implemented this with the margin of safety concept. We don’t need to know the exact intricate details of the policies, consumer spending, GDP and other factors affecting the economy. We just need to find a business, calculate the intrinsic value and apply a margin of safety. If we take 50% to be our margin of safety, we have already factored in the fact that our calculation is uncertain by up to 50% on the downside.

Going through a quick example, say company ABC is currently trading for $50. The spreadsheet calculates an intrinsic value of $100 assuming ABC grows at 10%. We buy at $50 because it is 50% of the intrinsic value, i.e. we have a 50% margin of safety. However, a recession causes ABC to slow down its growth to 5% and brings down the intrinsic value to $70. Although the intrinsic value dropped by $30, we will still manage to make 40% off our investment because we had already accounted such huge uncertainty.

Just Another Name

The uncertainty rating from Morningstar just seems to be a fancier way of saying margin of safety. The term “margin of safety” implies that we could be wrong, and I don’t think a company selling research and valuations want to hint that they could be wrong. But it’s great to see a major and popular finance business apply the fundamentals of value investing into a commercial package. Maybe Old School spreadsheets should be updated with the term “Uncertainty rating” ??