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Of upsides and downsides

Dec 12, 2008

Trying to think of things in a simplistic way can by very useful at times. It can help one achieve an overview of a certain matter, thus facilitating better decisions and preventing the person from getting stuck in the minor details. An example could be to think of the current valuation/price of a stock in terms of the upside and downside. Sometimes the PE at which a stock is trading is high because the future of the company looks very promising. And because its future seems so bright, people are not only willing, but at times are even very enthusiastic to pay a high price for the stock. Well, the problem with this is the uncertainty of the business world. As we are seeing so vividly right now, it can take hardly any time for the fortunes of entire economies to change, let alone individual businesses. Thus when you are paying a high multiple for a business because you are confident of its future, be sure that there are 'n' number of things that can go wrong in future for the business. Its management can change, it competition might get more aggressive, demand for its products can suddenly fall due to some external factors, its expenses might shoot up due to higher costs of some input it needs, the list goes on...

It can very well happen that the bright future forecasted for the company comes true. Thus in that case you will realize the gains in the way you had thought of earlier. But the probability of all things playing out as positively as you had envisaged are very low. Unexpected surprises can always be around the corner. Thus if you are paying a hefty price expecting that bright future to play out perfectly, your basically betting your money on a very fickle and vulnerable thing. An example of low upside and high downside could be paying a 50-60 PE for a good technology company in 2000.

Well the good news is that the converse of the above is also true. If you are paying a very cheap price for an inherently sound business, the downside to things turning out to be worse than those that are already being forecasted is relatively low. Thus the probability of the price falling drastically lower is also low. But what can happen is that things may not turn out to be as bad as what was forecasted, and positive developments can very well happen as unexpectedly. An example of high upside potential and low downside potential could be Indian banking stocks in June this year.

So trying to think of the price of a stock in terms of simple upside and downside can serve as a great guide.

P.S. - The only kind of businesses that should be considered for buying and selling from this kind of a perspective are businesses that have a proven track record and are inherently sound. Thus when we say 'technology stocks' in 2000 in the above write up, those companies which at the time did not even have any earnings to speak of, nor a proven sound business model, are not even taken into consideration.

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