Expected Value – judgment calls on probability

To a fundamental driven research analyst, he needs to get two things right: 1) different scenarios of earnings outlook for a company; 2) associated probability on each individual scenario. The former is what most analysts are usually focused on. For example, sell-side analysts always want to be right on next quarter earnings; buy side analysts want to be sure about a company’s earnings power under specific conditions.

The latter is rather subjective and hence not much attention given. However, almost in any investment case, the judgment call on probablities attached on each possible scenario is THE key for success and is what differentiates a good investor from a good analyst.

Datang International (991.hk) could be a good example at the current price (as of April 23, 2008, the publising date of the original article). It traded at HK$4.5 – 5.0. Due to a combination of factors including government cap on power tariff and rapidly rising coal price, Datang and other independent power producers’ margins get squeezed. As a result, Datang’s earnings for 2008 will likely drop to around Rmb 0.20 vs. Rmb 0.27 in 2007 without any help from the government on pricing increase.

The bull case on Datang is about its controlled access to roughly 20bn tons’ coal reserve it has been quickly accumulating. There is a wide range of view on how much these 20bn tons’ reserve are worth. In any case, if those reserves are fully developed, NPV could be well above the current stock price.

Now the question is: what to do with the stock?

Assuming both near term earnings estimate and long term coal reserve value estimate are accurate, there are two further questions to be answered: 1) what’s your investing time horizon? 2) what’s the probability you’d apply on each valuation number at THIS moment?

To a long term shareholder, he might ignore any near term stock price volatility if he is convinced about the investment story. However, he still needs to have a good handle on absolute downside risk if he wants to buy it smart.

To most other investors, particularly to a “Value Trader”, however, he needs to think real hard about the probability issue. In the case of Datang, the near term earnings downside bias is almost for sure given the high inflation pressure in China that will prevent the government from raising power tariff soon. So the probability for that to happen is high. A 15x P/E multiple would put the stock in low-3 to mid-3.

The massive coal reserve, on the surface, looks very attractive and could be treated as a call option even if you don’t know the technical detail for mines. Here is the key: what’s the probability for those coal reserves to be real and exploitabel at acceptable economical cost? It’s fair to say, given the lack of transparency, really not much faith can be put on these coal reserves. While they’re definitely worth more than zero, with the first meaningful coal production not to come until 2011, this is a long-tailed call option. Moreover, given the highly levered balance sheet Datang has, it requires capital raising through equity/debt market to ensure enough money to develop these coal assets. What if capital market doesn’t accomodate? Then the last question mark is: do we really know for sure these reserves are real?

In the end, it’s a judgment call. With a viewpoint that these coals are long-tail call options, they’re worth not much. In other words, probabilty attached with this outcome is small.

Therefore, Datang is actually an attractive short for a “Value Trader” even if we agree there is tremendous value in its massive coal reserves. This stance is totally different from a long-and-hold buyer who might be willing to hold onto the position even if the near term downside risk is quite big.


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