Extrapolating

Source: xkcd

Like many people, I'm spending a lot of my time during the age of Coronavirus sitting at home reading about Coronavirus. This abundance of free time, combined with a 24-hour news cycle that preys upon our hopes and fears, is a potent combination. Now everyone (myself included) is an amateur epidemiologist with thoughts about R0, drug researcher with thoughts about the effectiveness of experimental treatments, or economist / sociologist with thoughts about how best to re-open the economy while minimizing the structural harms to society.

The problem is that most of us are neither, and we're simply extrapolating from limited data in fields where we have no expertise. The number of prominent investors and businesspeople who have shared their completely unqualified thoughts about the spread of the disease and their purported cures for the economy are truly mind boggling. Just because someone is a good hedge fund manager (or businessperson, or nuclear physicist, or celebrity...) doesn't mean their thoughts on COVID-19 or predictions for economic recovery should be taken seriously. There is little evidence that they can predict the future even in areas where they are supposed to be competent in. I'm guilty of the same hubris, but at least some people have exercised a little humility.

Most reporters and writers, even for reputable organizations, are no better. They take the news headlines of the day and extrapolate them into a future years away. Today we have a "V-shaped" recovery, tomorrow it's the permanent end of public spaces and personal privacy as we know it. These predictions are meaningless in a world where we don't even understand the basic facts of the disease.

The truth is that nobody knows what the world is going to look like in a year, and the situation is changing so rapidly, with so many unknowns, that even if someone was correct it would probably be more luck than skill. And good luck identifying that person beforehand.

What does this have to do with investing?

I think that many people are making the same mistakes in extrapolation, based on limited or fast-changing data, for individual companies. Zoom Communications, a videoconferencing platform that has gained rapid popularity while everyone has been forced to work from home, is a good example. It trades at a 61 price-to-sales ratio, 1560 price-to-earnings ratio (not a typo), and its market cap is nearly bigger than General Motors and Southwest Airlines combined.

But these valuations only make sense if you extrapolate the current situation to the future with the same, inexorable logic as the comic above. Right now, almost everyone in the world is being forced to work from home by their governments in an unprecedented lockdown. It's hard to see how things get better for Zoom from here, unless you believe that the current, most restrictive lockdown rules are going to last for years, and further assume that Zoom will have no competition in this new, dystopian reality.

Similarly, it's easy to extrapolate into a endless spiral of negativity. Everybody knows that airlines are suffering, and air traffic has dropped nearly 96%. But even with all of the challenges that airlines face, it's hard to imagine things getting much worse from here. It will be hard for air traffic to drop below -100%. It's also hard to imagine a worse situation for travel than people being legally required to stay-at-home, or welded shut into their apartment complexes. The scope for improvement is far greater than the scope for increased negativity.

Of course, there is the risk of bankruptcy with these "traditional" companies. But there is also the risk of greatly overpaying for a Zoom. If I were to honestly examine all possible futures from now, rather than merely extrapolate the most pessimistic or optimistic future based on the headline of the day, there is realistically 1 scenario where there is upside for Zoom (endless pandemic, no competition, Zoom becoming the largest company in the world) and 99 scenarios where there is upside for airlines (basically, anything better than -96% people traveling).

But, what do I know?

Disclosure: Long LUV, GM, Banks and Other Traditional Companies That Will Probably Go Out of Business

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