Beware Simple Heuristics

I love simple heuristics probably more than the next guy, especially in finance. One of my most eye opening experiences during my early years as a credit analyst was when I was sitting in a room with a deal team and they were talking about pricing a new Term Loan B offering. The VP was like “How about 450?” The MD’s response: “That sounds about right.”

My little credit analyst mind was blown. Up until that point I always thought that decisions made in the world of high finance involved complex mathematical models. While that is often the case, a lot of it still comes down to simple heuristics.

However, you have to be careful whenever you use simple heuristics, especially backward looking ones such as price to earnings, price to book, or price to sales ratios. Take a look at the table below from Morningstar.

The above table makes it look like the stock is trading at the low end of its valuation range, doesn’t it? How about this next one:

It’s a slightly fuller picture but it too is currently trading on the low end of its valuation range.

The first chart was for United Airlines and the second chart was for JP Morgan. They both look like relative bargains based on the above. However, the reason they look like relative bargains is because the stock price of each company has deteriorated far faster than the fundamentals that have been reported in the tables above.

United Airlines is down ~60 percent while JP Morgan is down ~32 percent. It’s hard to say which one will do better over the next 10 years. I’d be comfortable making the bet that both still exist in 10 years, but will equity holders be rewarded for the risk?

Both companies have been effectively deemed Too Big to Fail by the US government, but both are facing significant hurdles: JP Morgan has to contend with ZIRP and whatever credit losses are lurking in its reserves while United Airlines will at some point have to offset its carbon footprint, assuming it doesn’t get crushed by its debt load.

You end up with the age-old conundrum. Either buy a basket of these types of companies and hope that investors are too pessimistic and the winners will make up for the losers or use a risk management overlay for the individual companies such as a trend filter or an OTM put option.

One way you end up as a Ben Graham value investor and the other way you end up as a trader. Only you can decide which one you want to be.

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