Acceptable and Non-Acceptable Scenarios for Companies

[moritz]

As discussed here in Investment Philosophy it might be very useful if I start creating clear descriptions of which scenarios are acceptable to me for each individual investment case and which scenarios are not.

That might help tremendously to focus on risks that go beyond acceptable scenarios and give more clarity and security when it comes to them. In addition, it becomes clear which types of developments I don’t regard as a problem and why I am ignoring them.

Over time we should go one step further and start discussing which scenarios should be acceptable or not. Depending on the case those discussions require a more advanced description of the whole investment case from my side which is something we want to definitely develop over time but what I cannot do for all companies at once and which is not a priority as of now.

Nevertheless, feel free to ask all kinds of follow-up and specification questions or ask specifically about different scenarios or start already criticizing what I think is acceptable. (I will consider the input but will not be able to get into a deep discussion on the subject as of now)

Here is an example:

Volkswagen
Based on 2022 annual numbers and today’s share price of €123 Volkswagen’s valuation is extremely attractive with a PE of approx. 4. (Does not even account for profits in China).
Volkswagen reinvested most of its profits into its electric transformation and growing portfolio of fully collateralized loans to it’s customers and distributed a 7% dividend yield.
Volkswagen remaining 75% stake in Dr. Ing. h.c. F. Porsche AG is currently worth more than it’s entire market cap.
While Volkswagen management guides to a positive 2023, potential troubles from a slowing economy seem to be more than priced into the by now.

Acceptable scenarios: Given the above-described very attractive valuation the following scenarios are totally acceptable to me and I would use the opportunity in case of falling share prices to increase the position:

1. Multiple years (2-3) without profits. In case the automotive market deteriorates heavily it would be fine for me if Volkswagen does not generate any profits for a while if we have a clear sense that old profitability can be achieved again.
2. Slowing shrinking profits. If profits shrink a few % per year due to some troubles it would not change my investment thesis. Root causes could be e.g. the transformation to EVs or a growing share of self-driving cars.

Non-acceptable scenarios: If we think the following scenarios are likely I would reconsider my Volkswagen position:

1. Company threatening losses. In case Volkswagen gets into a position in which it suffers heavy company-threatening losses due to the macroenvironment or other factors.
2. Dramatically different revenue and profitability outlook. In case we think Volkswagen cannot maintain its current profitability due to long-term changes in competition or a different environment coming from regulation, the transformation to EVs or self-driving cars.

What do you think? Do you agree with the usefulness? Is this format sufficient or do you need more/other information to start with?
Which company scenarios should I describe next?

[Magaly]

This is very useful. It would be cool to see at least for more important positions.

In the example of VW, your acceptable scenarios are based in the fact you think potential troubles are already priced in? and no much more downside in prices?

[moritz]

Ok thanks for the Feedback. I think will move ahead with this and create an overview for Upwork next.

Also pretty interested in your thoughts here Different Topics for One Company? as this influences where we will discuss Volkswagen acceptable scenarios in more detail.

[raff91]

I think the framework basically makes sense. I see potential weaknesses in the evaluation of whether a factor is threatening or non-threatening, as this can be quite subjective.
Perhaps this can be broken down a bit more systematically or a rough decision tree can be developed.

For example something like this (purely schematic, content has no meaning):

Of course, it is not easy to build a framework that covers all scenarios and eliminates any subjective deviation. But maybe you can at least develop something that objectifies and standardizes a large part of it. 80/20 like

[moritz]

Great point. We are actually in the process of researching graph drawing tools.
See: Knowledge Graphs and Decision Trees

The original purpose was to visualize our investment framework and dissect complex investment thesis into individual components that can be examined individually.

Mapping out decision-making is another exceptionally important part that could help a lot to clarify decisions and increase transparency and trust.

We want to do all of this publicly and invite anyone to participate in order to build shared investment models. The more scrutiny, criticism, ideas, and thoughts we get the higher the chance of catching flaws in the models early and hopefully making better investment decisions together.