Given the volatility of the market lately, I've been thinking a lot about Nassim Taleb's book Antifragile. One of the major ways it impacted me is that it helped me think about the types of businesses I'd want to own when market valuations are high but some stocks start to look cheap.
As Chris Cole of Artemis Capital Management has been talking about over the last few years, a large part of the market, value investing included, is implicitly a big short volatility trade. As Cole said in a 2017 interview with Real Vision:
There's nothing wrong with shorting vol if it's done intelligently.... I think the problem is that people don't always understand the risks that they're taking on.
...I think the problem, at the end of the day, is we're all short volatility. Every institution in the world is. The question is: are you short convexity, or are you massively short convexity? And do you understand that you are because, you know, we have a finite amount of life. At the end of the day...if you have a portfolio of value stocks, in some ways you're implicitly shorting correlation and betting on mean reversion.
That's a form of short vol. But the margin of safety can be attractive at the right points in time. The question is: do people really understand the risk they're taking on? I think when institutions are entering into a lot of these different strategies, and today this is just indexation to a certain extent, I don't think they...really have a pure conceptualization of all the risks that are going on.
Now, value investing, if done correctly, is the intelligent way to implicitly be short volatility, but Taleb's book also made me think more about the types of businesses that can turn whatever volatility may come into existence into opportunity. Or in other words, what types of businesses actually create value in tough environments? So as an investor, as long as you have the endurance to hold through whatever Mr. Market may have in store on the downside, you can actually come out on the other side in better position because of the work you did buying right beforehand. Examples from the 2008-2010 time frame would be things like Berkshire Hathaway on the large cap side of things, and Cambria Automobiles on the micro cap side of things.
I'm thinking more about this lately because while markets have come down a bit, they are still at lofty valuations. But I'm seeing more interesting things to look at that seem like they could be very cheap than I have in a long time, which is a bit ironic given that I just exited from the investment business and am not currently managing outside capital.
At any rate, while I was still at Boyles, we wrote the excerpt below in a 2014 investor letter after finishing Taleb's book, and I think it still reads fairly well, so I included it here for those that are interested.
Estimating intrinsic value based on cash flows, private market values, and liquidation values is something that should be familiar to those that follow a value philosophy; as is considering one’s downside in a worst-case scenario. And because these are estimates—and small changes in certain variables can have large impacts on expected values—it’s important to be conservative in those estimates. Or to use a phrase from Seth Klarman, it’s important to make those estimates “by compounding multiple conservative assumptions.”
Things start to get tricky when it comes to estimating probabilities, which one can’t really do with any degree of accuracy. It is too hard and too close to guesswork, especially when we consider that, according to Sir John Templeton, “No security analyst is ever going to be right more than two-thirds of the time.”
So if we can’t accurately estimate our probability of winning and losing, what can we do? What we believe an investor can do is determine whether or not the odds are likely to be in one’s favor. There are certain things that can increase one’s chance of not losing money on an investment, and certain things that increase the chance of losing should something unexpected or disruptive occur.
In Nassim Taleb’s book, Antifragile, he separates things into three categories:
The fragile is harmed by certain shocks, randomness, and stressors. The robust is neither harmed nor helped by them. And the antifragile grows and improves from them. As Taleb says, “...the idea is to focus on fragility rather than predicting and calculating future probabilities…”
So while we can’t accurately predict probabilities, what we can do is think about and identify traits that will increase our chances of winning and decrease our chances of losing under a range of scenarios. And by trying to avoid fragile traits and invest in situations that are more robust or, preferably, antifragile, we decrease our chances of making mistakes due to estimation error. Below are some examples of these traits among businesses and investments:
“...the fragile wants tranquility, the antifragile grows from disorder,
and the robust doesn’t care too much.” –Nassim Taleb
When the positive traits overwhelm the negative traits, we can be fairly confident that the odds are in our favor. But figuring out which traits are really present and which are illusory takes a lot of work; as does coming up with a proper and conservative estimate of intrinsic value and a worst-case scenario. The math behind the Kelly Criterion gives a good framework for thinking about the questions: (1) Is my probability of winning greater than my probability of losing?; and (2) Is my upside greater than my downside? But there is a lot of work that needs to be done in order to answer those questions with decent accuracy.
“It’s not supposed to be easy. Anyone who finds it easy is stupid.” –Charlie Munger
Using the Kelly framework to explain our current outlook on the investment climate, we can say that we see plenty of things with attractive upside ($W), but the main issue is that we also think there is plenty of downside ($L) in those investments. To optimize one’s capital over time, one should consider more than just the upside if things go right. One must be in the game long enough for the odds to work out favorably over time. The main reason we have so much cash today is that we see a lot of downside coupled amongst the upside.
We look for situations where, if we ran through the Kelly Criterion using conservative assumptions, it would tell us to take large position sizes. Our actual position sizes will, in practice, be much smaller than Kelly, as we manage risk and account for the uncertainties and errors that come with investing. But the idea behind taking big positions in one’s best ideas—especially when one’s downside is well protected—is one in which we firmly believe.
In the Ed Thorp article mentioned earlier, he also wrote that “Computing [F] without the context of the available alternative investments is one of the most common oversights I’ve seen in the use of the Kelly Criterion. Because it generally overestimates [F] it is a dangerous error.” And as we contemplate our alternatives to cash, we think not just about the current opportunity set, but also about opportunities that may possibly develop over the next several months. We’ve been and are still close to buying several things; and we continue to build our list of prospects. While we can’t know when Mr. Market will give us the opportunity to put our cash to work, we are ready to move in quickly when we think the odds and payouts are overwhelmingly in our favor.