Thread by @Sanjay__Bakshi

There is never just one cockroach in the kitchen. This is factually incorrect. If you take out all but one of the cockroaches from the kitchen, then there will be just one cockroach in the kitchen. 🤣

But the metaphor of "there's never just one cockroach in the kitchen" is valid for business and investment analysis.

Basically, the metaphor is about information asymmetry - there is information about some shit happening in a company - which is not yet public information. And that it will take time for this information to be fully disseminated.

But markets open every day. They have to price an asset in which “some shit is happening” even if all the shit that’s happening is not out yet (sorry about the pun).

So they take cues from the first news of “some shit happening” and respond accordingly. And most people have no idea on day one if the market is right or wrong.

The market consists of many kinds of folks. Some own the stock, and now that shit has happened, they panic and sell. Some who own it think of it as an opportunity to average down.

Or they don’t own the stock and think of it as cheap because it’s down 20% in a day, or that it’s fallen to a multi-year low, or the lowest P/E, or P/B in so many years etc.

There are all sorts of justifications to buy or to sell. Whether those justifications are right or wrong, only time will tell - when all shit has come out.

But the metaphor tells us something. It tells us that more often than not, the first sign of some shit happening in a company is not going to be the only sign and that there will be more shit that will come out, and it’s premature to buy in this situation now as an investment.

Notice the keywords "more often than not." The metaphor is not a law; it's just an observation of base rates of similar situations in the past. It merely tells us that usually happened in the past (but not always).

Not all market participants are investors. There are traders too. And some traders may feel that the market has over-reacted and there is too much negativity in the price and there will be one pop that will give them a decent upside from here.

But an investor cannot think like that. That’s because, an investment operation is one which, upon thorough analysis, promises safety of principal, and an adequate return. So wrote Ben Graham.

An investor needs a promise of the safety of the principal but when a company is going through shit and more shit may come out, then it’s not possible to evaluate how safe the principal is until all the shit is out. So this can’t be an investment operation.

In other words, one needs to have some sense of the worst-case scenario before thinking of the downside risk. And if that’s not possible right now (because not all the shit is out yet), then it cannot be an investment operation.

There is a nuance though which needs attention: Position sizing.

If he concludes that there is a significant downside (can't be more than 100% unless leverage is used) but that downside is more than offset by the potential upside, after considering probabilities, then he may be willing to expose a small part of his wealth to such an operation.

This operation will then be correctly classified as an investment operation because of (1) asymmetric payoffs; and (2) low exposure which guarantees the safety of capital at the "portfolio" level even though the investor may lose 100% in this "one" position.

This is why investing is so much fun. A conservative investor may stay away from such a situation but an aggressive one looking for a mispriced bet will look for exactly such situations. And both will be right in their own ways.

Another source of fun in all this is that if one waits for all the shit to come out, then there may not be an adequate return left in the situation because of competition with other investors, some of whom may be willing to take a little more chance with their principal.

So, the key here is to think about how much shit is still in there waiting to come out and how much of it is in the price already? Sometimes the price is so low that even if there is more shit in there, there is not much downside left in there. Sorry about the pun again.

In the end, figuring out how much more shit is still there and equally important, how much of it is in the price, is more of an art than science. One has to have a "feel" for these things to get them right.