It is unlikely that anyone who has a passing knowledge of the English language would be unable to describe what each of the words "won't," "may," "could," "should," and "will" mean. Yet in the investing world, the meanings of these words are often obscured in the haze of fuzzy logic, stress, and heated emotions.
I can sense the collective sound of people hitting "next" on their browsers. Please, I promise this won't be some sort of taxonomy on each word. And no, this article is not some great homage (or even a lesser one to the great Weasel Word Defense Act that is the Safe Harbor Provision). You can gather a great deal by paying attention to these words and their intentions to convey information, because each one offers a slightly different prognostication of something happening. Your ability to discern otherwise might give you some insights not into the topic matter, but into the speaker and his level of credibility.
This topic came up recently as I was reading F.A. Hayek's Road to Serfdom. It's an extremely interesting book since Hayek wrote it between 1940 and 1943, as his adopted home of Great Britain was embroiled in war against Germany, and by extension, the land of his birth, Austria. Hayek's a brilliant thinker, and one of the fascinating elements of this book is that it comes at the point when many British folks at every level had only just figured out that the National Socialism espoused by Adolf Hitler was pretty darn evil. Many British progressives -- who by wartime renounced Hitler and the Nazis -- had previously admired what the National Socialists had accomplished in Germany. Hayek's point was not to admonish these people for their stupidity, nor to praise them for their recognition of the realities of Hitler's regime. Rather Hayek noted that it was people of good will who paved the road for Hitler's thugs to take power, and that the same thing could happen in Great Britain if socialist policies were adopted.
Of course, the worst-case scenarios Hayek spelled out did not happen. Does this mean, then, that Hayek was wrong? (Whether Hayek's other premises have or will come to pass is a discussion well outside of the scope of this article.) No, absolutely not. Hayek noted potential outcomes. History shows that reality in the intervening years took a different path. What Hayek made, in effect, was a statement of risk.
Being right vs. playing the odds
Too many people view investing and business as zero-sum games. "If you believe X will happen, and if you invest accordingly, and if it happens, you have inarguably made a good decision." Or, if you do the opposite, that you have necessarily made a bad decision. While such thinking may pay off handsomely on an individual case basis, it is unlikely to get an investor to the Promised Land in the long run. That's why "may," "could," and "should" ought to be such core elements to your investing lexicon. Between the three of them, you can determine that a company valued at 45 times book value, 300 times current earnings, and 70 times the mythical "next year's earnings" doesn't offer a good risk-reward ratio. This company, by the way, is Taser (NASDAQ:TASR).
Could Taser grow at the sustained triple-digit rate needed to justify today's stock price? Yes, trends in law enforcement make this a possibility.
How much growth should investors assume is already built into the stock? At this point, Taser will need to produce high growth rates for an extended period of time, without substantial dilution.
What may happen if Taser grows even just a little bit more slowly? The stock is priced for perfection. A minor miss in meeting expectations could be disastrous.
How much more relevant are these questions than "Is Taser going to grow at necessary rates needed to justify today's stock price?" Actually, they're as different as night and day. One set of questions is thoughtful, and the other is not. Nothing is definitive in business until it has actually happened. Until that point, it's a probability. Beware the definitive, and beware giving yourself too much credit for predicting any single outcome.
Perhaps the best allegory here comes from poker. As noted poker player Puggy Pearson famously said, "Ain't only three things to gambling: knowing the 60-40 end of the proposition, money management, and knowing yourself. Even a donkey knows that." Thanks to Lakes Entertainment's (NASDAQ:LACO) wildly popular World Poker Tour television series, millions of Americans have now seen what poker games at the top levels look like. Investing isn't very much like games of chance, but it does have a great deal in common with a game of skill like poker. Players use the information they have, they use the information they deduce (sometimes incorrectly), and then they use probabilities -- i.e., they determine risk/reward ratios. And sometimes, just sometimes, one of the best players in the world holds a pair of kings, bets the ranch, and loses. Bad bet? Under most circumstances, the answer is no.
To sell or not to sell?
Unlike poker, investing isn't self-contained. There is no end point where you get to lay your cards on the table and collect your chips. The game is endless. It's possible to sell a stock, win, and then lose as the stock churns upward.
This happened to Fool co-founder David Gardner in the not-so-distant past. One stock he recommended for Motley Fool Stock Advisor, Netflix (NASDAQ:NFLX), had rocketed higher, to the point where he determined that there was a great deal more risk than potential reward in continuing to hold. David sold the company in early November. At this point, five months later, Netflix is substantially higher in price than when David sold.
I've never discussed this particular action with David Gardner, but I doubt that his reasons for selling included the following sentiment: "The stock won't go any higher." Nor would I suspect him to have said, "The stock will drop." These sorts of statements would be clearly absurd and show a basic misunderstanding of the nature of the stock markets. Anything that has gone up can continue to go up, even if you have a pretty big bully pulpit from which to state your opinions or intentions, as David has.
And here we sit, a few months later, in the midst of a giant speculative surge that has swept up equities of every shade of quality, and Netflix is higher. Much higher. Did David make a mistake? Well, he recently wistfully noted that he wished he still owned the stock, but beyond that I'd guess no, or at least not yet.
Smart sell decisions are not based on some spectacular timing, in which you've squeezed every penny out of an overvalued stock. A smart sell decision comes when you recognize that a stock's price makes you uncomfortable, at a price where you believe that the company's performance is going to have to be pretty darn special to fulfill the expectations presented by that price. And if those magnificent expectations are eventually fulfilled, would we then be able to declare the seller wrong? (I'm speaking generically, not necessarily about Netflix.)
Perhaps, but not necessarily. What could be wrong is your assessment of probabilities. If you think that a company has a 5% chance of meeting expectations, and the reality is that its chance of succeeding is much, much higher, well yeah, you're as wrong as can be. But a 2 or 3 sigma event will by definition occur 5% or 1% of the time. Sometimes the long shot comes in. Occasionally you get the gut shot to make the straight. But unless you're being compensated for this level of risk, it's not the way to bet. It might happen, but it shouldn't.
Warren Buffett has invested this way his entire life. He's willing to forgo the potential of a great outcome for the next best thing to a sure thing. As you might be able to guess, this strategy has worked out pretty well for him, as the appreciation of Berkshire Hathaway (NYSE:BRK.A) shares over a 25-year period shows. Watch those "wills" and "won'ts." They might cost you big-time.
Bill Mann would like to note that his least favorite radio sound is sirens, followed by traffic, followed by almost any eating sound effect. Bill holds shares of Berkshire Hathaway. The Motley Fool is investors writing for investors.
