"In dealing with the future, we must think about two things: (a) what might happen and (b) the probability that it will happen."
--Howard Marks, The Most Important Thing
Before we dive into stocks, let's take a quick trip to the horse track. Let's assume that I have a supernatural handicapping ability (if only!) and that we can rely absolutely on my expectations for how these three-horse races shake out.
Here's what race one looks like:
|
Horse |
Probability of Winning |
Payout |
|---|---|---|
| Mr. Luckee | 50% | 1.2-1 |
| Candifromababy | 30% | 2-1 |
| Gaga's Nightmare | 20% | 15-1 |
And race two:
|
Horse |
Probability of Winning |
Payout |
|---|---|---|
| Obamaslefthook | 70% | 3-1 |
| Sinatra Sloe Jam | 25% | 2-1 |
| Usain on Hooves | 5% | 15-1 |
With this information at hand, where would the smart money go on these two races? In the first, Mr. Luckee has the best chance of winning, but on a $10 ticket you're only going to win $12, which is a terrible return for that win probability. Gaga's Nightmare, on the other hand, may be the horse least likely to finish first, but bettors have such a low opinion of the horse that the payout more than compensates for the low probability of a first-place finish.
The second race is the exact opposite story. The longer shots have been bet down enough that the winning payouts won't adequately compensate you for the risk you've taken. The payout on Obamaslefthook may not be nearly as large as Gaga's Nightmare, but given the high expected win percentage, that horse would make an excellent bet.
Back to stocks
Just as with the horse racing example above, the calculus of investing isn't simply about what could happen or even what's likely to happen. As the Howard Marks quote stresses, it's important for investors to consider the probability of various outcomes. That calculation -- even if inevitably imprecise -- provides a basis to consider how investors are pricing assets and whether they are being unduly optimistic or pessimistic.
This process can certainly be applied to individual stocks. However, it can also be applied to broader market themes. For example, sober investors in 1999 may have seen that there was a high probability that the Internet and new technology in general would change the world in major ways. However high, though, that probability may have been, stock prices were so high that they didn't compensate for any but the most optimistic of outcomes. Investors betting against tech stocks, or simply placing their bets elsewhere, were the winners during this period.
On the flip side, in the midst of the credit crisis, full financial Armageddon seemed possible. Wipeout. Zeroes everywhere. Full stop. Even at the worst of it, though, that truly extreme outcome was still a very low probability. But investors priced many stocks as if the Mad Max scenario was a very high likelihood. Investors who saw this misperception and bought stocks when the Chicken Littles were squawking the loudest have done quite well.
Three themes for right now
So what are some themes that investors can be digging into right now? Here are a few that have been on my radar.
- The interweb strikes again! The IPO market has started to heat up again for tech stocks. Now let's be clear -- we're nowhere near the frothiness of the dot-com era. However, companies that have come to the market with buzz words like "cloud computing" and "social networking" have gotten a rabid reception from investors. Zillow (NYSE: Z) is up 78% in roughly a week, HomeAway has soared 52% in roughly a month, and Fusion-io (NYSE: FIO) gained 60% since early June.
- Bank is a four-letter word. There are a few bank stocks that investors think can do no wrong. Bank of Hawaii, for instance, recently missed earnings estimates, and the market couldn't care less. However, many major banks are trading at multiples that suggest investors have exceedingly low confidence in any sort of banking stabilization. JPMorgan Chase (NYSE: JPM) currently trades at less than book value, PNC Financial (NYSE: PNC) also trades below book value, and Bank of America (NYSE: BAC) doesn't even fetch half of its book value. All three of these stocks historically traded at 1.5 to two times book value.
- Too big to succeed? Large caps continue to look very attractively priced against their smaller counterparts. By splitting the S&P 500 index into four groups based on size, I found that the largest stocks had a median forward price-to-earnings ratio of 13.4, while the smallest had a P/E of 14.9. Think it has to do with higher growth from the small companies? Good thought, but not quite. The median PEG -- that is, P/E over growth rate -- for the S&P giants is 1.1, while it was 1.3 for the stocks in the smallest quarter. With stocks like ExxonMobil (NYSE: XOM) and Microsoft (Nasdaq: MSFT) trading at less than 10 times earnings, it's tough to pull myself away from the large-cap hunting grounds.
Obviously these are only a few of the many possible themes that you can dig into to find good investment opportunities. To dive into yet another -- high oil prices -- you can check out the free special report that a few of our Rising Star analysts have put together.
