Do not get emotionally attached with the company you are appraising

Hello dear reader (diary), it has been ages since my last post. I have been busy and short of ideas and considerations. Actually, I had some ideas but they were too confused to worth making them public. To make amends for my prolong absence I will write about a troublesome topic. Authenticity and sincerity in your forecasts and assumptions.

I know is incredibly easy to party for the company you have been reading about and analyzing for days and weeks. The CEO and CFO wrote touching letters promising you to make this world a better one and achieve outstanding goals. So with this enthusiasm you start modelling your spreadsheet with overconfident forecasts that deliver a 2x upside potential.

I understand that is irritating ending up with a target price below the current price. You may think that all the time spent in your analysis has been wasted and that you may have channeled all your efforts in another company that offered a better return. So as a result you tend to input overconfident growth rates and a lower WACC because you are dragged by your emotions. In fact, is easier to justify all your time with a Buy but we are not doing this to sell an idea or incentivize to make any particular trade. We should avoid embracing any biased action that can turn against us. Remember, unlike brokerage houses and IB, we are free from any conflict of interest. That's why most of the sell side researches out there are just waste paper.

Coming back to our story. You log in your broker and buy your beloved stock. At the first turbulence in the market you begin to revise your spreadsheet and start noticing that maybe (MAYBE) you have been too generous with your assumptions. That's the moment your blood runs too fast to your brain, you stop breathing regularly loosing your clear thinking. That's precisely the time where you'd better keep your mind clear and most importantly you need to have a rock solid investment thesis. At this point in time is almost impossible to revise your estimates in an objective way, you will certainly be conditioned by the current emotional and market status. Well nobody is dead yet, you could take the loss go back to your homework and decide whether to invest again or not. Or you can just close your eyes and hope that the crash does not hurt you too much - you can also be blessed by fortune after all.

I wrote this short story to highlight how crucial it is to be sincere with you future expectations. But also to warn you how easy it is to get carried away from your emotions putting your wealth at risk.

Solutions?

Make a sensitivity or scenario analysis. Understanding how sensitive your target price is against your assumptions is crucial to assess the soundness of your model and detect signs of overconfidence. It also allows you to know the change in the target price in case of a negative effect on your inputs. Adding layers to your analysis increases the chance to avoid painful mistakes.

Remember that in investing, not to invest is also a way to generate alpha.

Peace!


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