All the outcomes are unknown

by Cole Smead, Smead Capital Management

We go through life being taught far more certainty than is actually present. Life isn’t black and white, but instead various shadings of grey that end in black or white, only after the fact. As a recent example, I went to the Rose Bowl to watch the University of Washington versus the Ohio State University. The sports books had assigned the Ohio State Buckeyes with anywhere from a 6.5 to 7-point advantage in the game. I sat at the game (as any avid underdog would) hoping my team would pull off an upset.

For the first three quarters of the game, all had been lost. Washington was being dominated by their opponent. It seemed like they had no chance to win the game, nor beat the spread. Washington Husky fans depressingly left the game early during the third quarter, which ended with a score of 28-3. It seemed very black and white.

In the end, Washington rallied in the fourth quarter, scoring 20 points. They lost by five points, but beat the spread. Talk about bad beats for gamblers that bet on Ohio State to beat the spread. Ohio State spread-betters looked like they had things locked up at the end of the third quarter. The final result was that Ohio State betters lost all their money. Something “unexpected” took place because Washington figured out how to score touchdowns. Investors must remember that all outcomes are unknown in advance.

Any time we do something, we build a likelihood in our mind, consciously or sub-consciously, of whether success will be attained based on our abilities, past experiences, etc. Everyone knows that the dinosaurs have long been extinct. Annie Duke wrote in her book, Thinking in Bets, speaking on coelacanths, a fish:

A mass-extinction event (such as a large meteor striking the Earth, a series of volcanic eruptions, or a permanent climate shift) ended the Cretaceous period. That was the end of the dinosaurs, coelacanths, and a lot of other species. In the late 1930’s and independently in the mid-1950’s, however, coelacanths were found alive and well. As species becoming “unextinct” is pretty common.

We generally accept things that we hear from others up until the point that we have to place a wager on what the right answer is. As Duke teaches us, this is more common than we think. Putting our money where our mouth is helps us think more correctly. When we state something we believe, and someone asks “wanna bet?”, our mental acuity sharpens.

Later in her book, Duke shows this through studies on traditional peer review.

Experts engage in traditional peer review, providing their opinion on whether an experimental result would replicate, were right 58% of the time. A betting market in which the traders were the exact same experts and those experts had money on the line predicted correctly 71% of the time.

In security markets, capital is always at risk, but not necessarily by the owner directly. There is an element that must be added: what others think and are willing to pay for what they think. In a world where the outcomes are unknown, price is the great arbitrator. As the Rose Bowl showed, it wasn’t that people were wrong that Ohio State was more likely to win, it was the odds they were willing to accept to make their bet.

As fellow investors are reading this, topics that should come to mind are our discussions over the last year about value vs. growth, or the economy based on one’s long-term view of housing. In our opinion, these are all examples of unknown outcomes that people believe are known and are paying dearly for the clarity they believe they have. We don’t know outcomes and thus rely on prices to be one of our main guides.

To bring this to a more company-specific discussion, we’d like to talk about the current conversation with media stocks. In a recent Bloomberg article titled “Comcast, You Can Thank Netflix for the Win,” the author stated:¹

With the media industry so fixated on the cord-cutting trend and the shift to streaming, a simple point that often gets overlooked is that new streaming services require a good internet connection. And who sells those internet connections? Cable providers such as Comcast Corp. That means the same old cable giants whose steep monthly bills had consumers fed up and flocking to cheaper TV-entertainment options are actually still benefiting from the rise of streaming. That also buys Comcast time to figure out how to build its own Netflix-like service.”

This comes off almost counter-intuitive for the author of this Bloomberg piece as it seems odd that an incumbent business, the original cable business, would be helped by the new streaming services in the industry.

We were reminded by our CIO Bill Smead in our most recent webcast that AOL was once on top of the world when the movie You’ve Got Mail was released, starring Tom Hanks and Meg Ryan. AOL was once the largest internet service provider in the USA and commanded respect and adoration by all on Wall Street. However, they didn’t own the pipes, only the services provided to get you connected on the internet. Few people foresaw the gravitational shift that was going to happen as the fast growing cable business of the 1980’s and 1990’s became today’s dominant provider of internet services. AOL has disappeared into the sands of time.

In other words, at that time no one had a clue of what the outcome would be. It was truly unknown. Even so, market participants were paying nose bleed multiples in their belief that AOL was going to be the end-all for internet services. They were wrong on their outcome and wrong on the price.

As was true then, investors are paying dearly for the outcome they believe they know. Netflix trades for 125 times trailing earnings. Comcast, in comparison, trades at 14.4 times. Despite the completely unknown outcome, the odds look strangely tipped as they have before.

All the outcomes of the investments we own are still unknown. If they were known, we believe we would be paying far higher prices. We are biased to spend our time asking whether we are getting a good price for the companies that we own. As we look at the end of 2018, everyone believes they know that the days are numbered for the incumbents in the media space. We would argue that the jury is out on this and all other future events. We believe our job is to find good outcomes at very favorable prices.

Warm regards,

Cole Smead, CFA

¹Source: Bloomberg

The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Cole Smead, CFA, Managing Director and Portfolio Manager, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

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