Over the last few weeks, there have been numerous unexpected events that have caused significant pain for the shareholders of some large and widely-followed corporations.
In the month of March alone:
· Boeing shares fell 12%, wiping out $28bn in market capitalization, as a second 737 Max crash in less than six months validated concerns of a manufacturing fault in the next-gen aircraft.
· Bayer fell 13%, losing $8bn in equity value, following another legal ruling linking RoundUp to a Californian plaintiff’s cancer.
· Biogen fell 29% - an $18bn hit to its market value, as the company announced the failure of a promising Alzheimer’s drug under development.
In researching our investments, we will of course consider all of the known knowns – the liabilities a company has, it’s economic sensitivity, the strength of the balance sheet and various other ‘risk factors’. But there will also be, in the parlance of Donald Rumsfeld, “known unknowns” and “unknown unknowns.”
Of the many possible ‘known unknowns’ obvious examples would be an upcoming regulatory review for a utility company or financial institution, the process of bringing a drug from research to market, or for many companies litigation that is in progress. And recently, many politicians have called for large technology companies to face greater regulation or even be broken-up to counter their perceived monopolistic power. Investing is both an art and a science and factoring in the known unknowns into an investment case requires reasoning and judgment: what are the range and probabilities of different scenarios, the timing of such catalysts, and the financial consequences of different outcomes?
When the unexpected happens, or the ‘downside scenario’ hits a company, in most cases one can watch from the sidelines and be thankful that “there for the grace of God, go I”. But in some situations, action is required: whether to join the rush for the exits or stay the course (if you’re unfortunate to own the security), or even look at the decline as a buying opportunity. In December, Johnson & Johnson fell almost 10% the day Reuters published a story claiming the company knew for decades that there was trace elements of asbestos in their talcum powder and they hid this from regulators and the public. The company has strenuously denied the allegations, continues to defend itself in court proceedings and insist the product is safe. In considering the impact of this new development on the investment case for the company, it is worth noting that baby powder accounts for less than 1% of J&J sales and the lost market capitalization following the Reuters story ($32bn) is much greater than what most analysts (and even some of the plaintiff’s lawyers) believe any potential settlement would cost.
In being humble in our ability to predict the future, we tend to shy away from situations where the range of outcomes is too wide – we’re investors after all, not gamblers. But in some circumstances, share prices overreact; factoring in all of the risk and little prospects that the negative catalyst is either temporary, less bad than feared or fully priced in. If a company has a strong balance sheet, perhaps other more significant lines of business, or still bright prospects despite the set-back, the risk-reward of taking an appropriately sized position in a name can be the correct call.