How to invest like Chuck Norris

How to invest like Chuck Norris

Action hero and martial artist, Chuck Norris is widely associated with an internet meme that documents fictional and often absurd feats associated with him. Now, wouldn’t it be handy to have some of those supernatural powers when making investment decisions? Because the future is full of unpredictable events that can really play havoc with your investing.

Speaking of the unpredictable, one of my favourite quotes comes from Donald Rumsfeld.

“As we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.”

Just as this is relevant for defence strategy, it is crucial to remember in investing. Each of these information pieces requires a different approach and is most valuable at a different stage in the investment process.

Known knowns

Difficulty level: Beginner

Best used for: Historical analysis, first glance

The easiest bits of information to interpret are known knowns. These are readily available in company reports, industry data, broker research and market research. What’s more, it’s growing – and very rapidly thanks to big data (you can now pay to see live satellite images of a crop yield, construction site or cars outside a store).

This expanding universe of information comes from a broad range of sources:

• Company reports/ announcements – these are a great place to start
• Known competitor reports
• Industry reports
• Research/ marketing reports

This can be very helpful for understanding the status quo – where market share is at, what growth rates/ margins we are seeing today and what they were yesterday. This information is known, historic and factual – we can use it readily.

Known unknowns

Difficulty level: Advanced

Best used for: Forecasting, base case, sensitivity, understanding a range of outcomes

Once we have examined the known universe of information – in order to forecast the future, we need to move beyond this. To forecast effectively we need to examine the known unknowns.

We cannot know what next year’s margin will be – but we can look at the revenue and cost drivers to understand a reasonable range of outcomes in the next result. We know that the AUD/USD is volatile and can affect earnings for companies with US operations, but it is near impossible to predict. What we can do is work out how sensitive profits are to a change in the currency and know that the future earnings are dependent on this known unknown.

As analysts we deal with numerous known unknowns – every assumption in a DCF is ultimately a forecast. Some of these unknowns are easier to understand and predict than others. On the nice side of the spectrum, a company may disclose FX sensitivities in their annual report. On the more difficult side, the ACCC may be reviewing a merger and have a truly unknown outcome to deliver to the market.

Whilst we cannot predict the known unknowns with 100% certainty, we can gain an understanding of the range of possible outcomes. Sometimes we can even quantify their effects on future earnings. Regardless, predicting the unknown is a truly difficult task and requires a deep understanding of the competitive dynamics, industry growth and intricacies of a business.

Unknown unknowns

Difficulty level: Chuck Norris

Best used for: keeping yourself grounded

The final category is the unknown unknowns. As with the military, this is the hardest category to account for. This often creates the largest “surprises” and share price reactions in the market, but it is truly unpredictable. Just as you can’t predict walking past a $50 note lying on the ground, you cannot predict a take-over announcement, the development of a new technology or the loss of a key contract. Some recent unknown unknown events were the Downer bid for Spotless, and Japan Post’s bid for Toll holdings. You would have had to have had a crystal ball to predict those.

So how do you account for the completely unpredictable? The approach here is two-fold:

1. Concede and acknowledge that you cannot predict all aspects of the future. There is an element of the unknown ahead and being aware of it sets you up well to react rationally when it occurs.
2. Try your best to minimise the size of this category by focusing on a wide range of known unknowns. Think outside the box and don’t just limit your known risks to those on the annual report. You may not have been able to predict the recent Private Equity interest in Fairfax – but you analyse what a potential break-up valuation would look like. You cannot know that a company will cut their prices, but you can do a sensitivity analysis on what that would do to underlying earnings.

Whilst we deal with an uncertain future – it is possible to plan ahead and be more prepared for the range of possible outcomes that are to come. Although we cannot completely eliminate it – we can endeavour to minimise the size of unknown unknowns.