Stalking the Black Swan by Kenneth A. Posner

Author:Kenneth A. Posner
Language: eng
Format: epub
Publisher: Columbia University Press
Published: 2010-11-25T16:00:00+00:00

Reviewing the Second-Quarter 2001 Surprise at Providian

To illustrate the idea of real-time updating, let us return to the Providian story at the point where I was starting to worry about the sustainability of Providian’s business model in the wake of its run-in with the Office of the Comptroller of the Currency. As part of the settlement, regulators ordered the company to cease deceptive marketing practices. It complied by instituting new controls, improving disclosures, writing more careful scripts for its telemarketers, and hiring a well-regarded chief compliance officer. Some investors worried these changes might hamper growth, but so far there was no evidence. I had initially assessed a 50% probability of problems with the business model, as illustrated in the probability tree in Exhibit 5.8.

When the company reported second-quarter 2001 results, I noticed the rapid amortization of the balance sheet account, “deferred revenues,” which, as explained in Chapter 2, implied a sharp falloff in cash revenues. How should this new information have changed my view of the odds?

To answer this question requires assessing the new information’s diagnostic power. Was the amortization a reliable indicator of business model problems, or might it have been a kind of false positive, explainable by some other cause? This is the kind of question for which there is no database. To answer it, I had to imagine different scenarios that might have produced the signal, such as an undisclosed change in accounting policies, or revenues from new products hitting the books over a longer time period.

On the basis of this line of reasoning, I estimated a 70% probability of observing the deferred revenue amortization signal in scenarios where the business model was actually under pressure. (In this case, the signal would be a valid indicator of problems.) At the same time, I thought that even if the business model were actually fine, there could be a 20% probability of observing the amortization (this would be a false positive). These estimates are located on the second node of the probability tree in Exhibit 5.8, under the heading “Conditional Probabilities.”

To be sure, these are all subjective estimates. Nonetheless, the probability tree lets us calculate a revised probability for business model pressure consistent with these estimates. We calculate this revised probability by dividing the terminal probability for the “true” indicator branch (35%) by the sum of all terminal branches where deferred revenue amortization is observed (45% = 35% + 10%). The revised probability is 78%, a sharp increase from the prior estimate of 50%. My alarm on reviewing these results (I was recommending the stock) should be understandable.

EXHIBIT 5.8 Estimating the Diagnostic Power of New Information at Providian

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