Saturday, April 11, 2015

Is too much math bad for investing?

“If you need to use a computer or a calculator to make the calculation, you shouldn't buy it.”
Warren Buffett

We've already talked about the LTCM debacle and they were very good with their math. There are entire funds running based on mathematics today such as Renaissance technologies and other statistical arbitrage shops. These products are good and probably very few statistical arbitrage (statarb) shops are able to do this consistently. Even statarb shops have to sit it out when they are unable to find any opportunities. Then why does Buffett say don’t do the math?

In the scope of value investing where you are trying to get as concentrated as possible if the valuation is so complex that you have to run detailed calculations to prove that its cheap then your margin of safety is low. Another problem with the math is that the more complex the math gets the more assumptions get baked into it. These assumptions may or may not be true. As we have learnt earlier the variables affecting a business are infinite and cannot be modelled into a spreadsheet.

Let’s run with an example here. If a company is trading at 10 times earnings with 3 times earnings of debt, with a return on invested capital of 25% and you think it can double its earnings in 5 years – is it a good buy? Now we can run amok with discounting and prove that this is probably running at a discount but just for argument sake its do this with common sense. If it doubles its earnings in 5 years in a linear fashion it is going to earn approximately 1.5*5 of profits over the period which is 7.5 times its annual profit. This is more than enough to return the entire debt. Given that its return on invested capital is 25% and it is going to be growing at approximately 15% (2^(1/5)) which tells you that after returning the debt it should be paying a dividend of 40% (10%/25%) and after 5 years its earnings would be 1/5 of your purchase price or equivalent to a bond yielding 20% every year. This should probably tell you that it’s a screaming buy because you don’t get bonds that are growing their yield by 2x every 5 years yielding 20% a year! On the downside if you believe it can at least just generate just its earnings and you believe they are good capital allocators then the debt can be returned within 3 years and at the end of the 3 years you could get a dividend yield of 5% to 8% which is also not bad.

Of course there is much research that goes into making the assumption that the company will grow its profits by 2x in 5 years. But those assumptions will have to be subjective and based on the business environment.

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