Thursday, April 17, 2014

What's the worst case scenario?

Survival and end of the world scenarios seem to be en vogue.  From the preppers to the impending financial collapse of Japan/China/Europe/US there's a very vocal subset ready for a collapse of something.  Investors are preparing for another market crash, and it seems like journalists are writing about bubbles to capture page views.  I'm not sure if doomsday has always been so popular, but it's been something I've been thinking about recently.

Last week I drove up to Toronto to attend the Fairfax shareholder dinner on Tuesday night.  At the dinner we had a chance to listen to various Fairfax executives discuss their company and issues they felt were important.  One executive discussed her view that China is on the verge of an impending collapse.  Fairfax Financial in general is bearish on both the market and various countries, they predict that we'll experience deflation along with a Chinese implosion.  Their outlook is very dire, and it's not an uncommon view held by investors.

While I was listening to the Fairfax executives discuss China I started to think about a friend of mine.  He is a former survival instructor in the Air Force, he'd take students into the woods and show them how to kill game, find water and survive enemy tourture techniques.  I was always fascinated by his stories about eating goat eyeballs or being dumped in the desert without water, the training was intense.  Beyond his survival skills my friend also has a keen sense of business opportunity.  After leaving the Air Force he and his wife started one of the first drive through coffee shops in Pittsburgh.  It was no surprise when he wrote a book catering to the prepper movement based on his Air Force survival training.  For my foreign readers who need a little background; preppers are Americans who are scared about terrorists or a revolution, or nuclear attack who in response have fortified their house, stored food, and train to thwart attackers.  The prepper movement has spawned TV shows, books, and training courses to prepare for some terrible event.

My friend wrote a book about an EMP attack in the US.  I haven't read the book personally, but I'm familiar with it.  In the book civilization breaks down as a result of this attack and Americans are forced to fend for themselves.  The book is part survivalist manual, and part story.  From this launching pad my friend started a consulting business and is now in the business of writing other material for the prepper niche.  I doubt he ever thought he'd be making a career out of experiences from the Air Force, but he saw opportunity and took advantage.

I find the societial collapse scenarios and obsession fascinating.  There is a whole plethora of scenarios that could potentially take America from eating McDonalds and drinking Coke to fighting each other in the streets, growing food and living in some anarchist society.

Story lines for a societal collapse remind me of story lines for market collapses.  If A happens then it will lead to B, which in turn leads to C, which results in D, after which we're all living in huts with loin cloths and grass skirts.  The problem is outcomes are never as neat and tidy as the story lines we tell ourselves.

What's intriguing about all the collapse scenarios is that although we have a lot of stories and theories of collapse if one looks back in history there aren't that many examples of a total collapse.  There are examples of governmental breakdown and disorder in societies, but none that I know of have led to people living as they did in the stone age.  I'm astonished at the number of groups pushing for a total collapse.  From environmentalists preaching about our energy usage, to right-wing militias it seems like each of these groups has an agenda to push.  Each group is selling something, and if we don't adopt all of their changes we are led to believe we'll experience a worst-case scenario.

For some reason humans are attracted to the worst case scenarios.  We want to be worried about something remote and unlikely to happen.  We're worried about an EMP explosion (do they explode?) that knocks out the electricity grid, but we're not worried about unsafe drivers on the roads.  We're worried about China collapsing and destroying the market, but we aren't worried about buying into an over-levered company with a dying business model.  We over estimate remote risks, and under estimate reasonable risks.

Evidence to support this can be viewed in the comments on this blog.  Many commenters have posted very valid worst case scenarios about companies as a reason to avoid the investment.  The worst case scenario sounds attractive, and it's easy to buy into the story line, but is it relevant?  If you look back at a lot of those worst-case scenario comments you'd see that the scenarios never materialized, rather a much better scenario unfolded.

When a company is trading close to or above a fair value a lot of things need to go right, or continue to go well in order for the company to grow into their valuation.  Sometimes a company does everything right and a seeming overvalued turns into a missed buying opportunity for investors.  There really are companies out there that can grow sales 25-50% a year for stretches, I've worked at one in the past.  Growth like this doesn't last forever, but it lasts long enough that a high valuation can be deserved.  Just like there are star athletes, there are star companies that make all the right decisions for a period.

When a company trades for a low valuation not many things need to go well.  It's the opposite, as long as a company avoids failure or disaster they are often worth more than what the market is pricing them at.  Valuation trumps risk, at some point a valuation will be so depressed that even the most unpalatable prospects can be enticing.  I know investors will disagree on this point, but outside of purchasing nuclear waste or something toxic like that I'm guessing that most investors would take even the worst business in the world if offered for almost nothing.

A lower valuation protects an investor against terrible outcomes.  Competitive advantages, and concerns about a moat disappear as a stock's valuation drifts lower.  Below a certain point if the company continues to simply conduct business they are worth more than their valuation even if the market disagrees.  What seems to happen is the market latches onto worst-case scenarios and ignores more likely near term scenarios.

Humans are incredibly creative and able to react in unpredictable ways to situations.  Investing in companies with extremely low valuations is akin to betting that we will witness human ingenuity.  When a company is facing dire circumstances often management will do uncharacteristic things in order to both save their jobs and save the company.  Sometimes those actions work, not always, but enough.  Othertimes conservative management can be forced out of their comfort zone when competition is at their doorstep.  A previously sleepy company catches the growth bug and both management and investors are rewarded.

Human ingenuity and creativity are part of the reason I don't buy into worst-case scenarios.  When we start heading down a bad path few sit by and let events run their course.  Our normal response is to do something and try to fix the situation.  When a country heads towards collapse a group of citizens will step up and attempt to fix the situation, altering the course of events.  Companies are no different, few management teams sit by idly as a company falls apart.  It's the action that people take that creates unpredictability in our story lines.  Suddenly the A->B->C->D story line is disrupted because between B and C people stepped in to do something.  Sometimes a fix works, othertimes it doesn't, but it always alters the storyline.

When we buy into companies or countries at high valuations we are implicitly betting that a best case scenario will unfold.  If it doesn't then we are at risk of losing money.  When we invest in a company or a country with a low absolute valuation we are betting that human ingenuity will attempt to do something, and that we'll avoid the worst case scenario.

I look at a lot of companies that the market and investors have written off as worthless.  Many are worthless, they have management teams working to extract all of the value for themselves while the company coasts to zero.  But some aren't worthless, investors might have fears about them, but at a low enough valuation these fears can be overcome.  Absolute valuation is critical, keep that in mind and risk will fall into place.  Items that are risky at 2x BV and 30x earnings are non-issues at 50% of BV and 3x earnings.  Focus on what's likely, not the unlikely worst-case scenario.  And lastly when buying something at a depressed valuation realize that you're making a bet on human creativity and ingenuity to do something to resolve the situation.  The response might not be perfect, but nothing in life ever is.  A reaction doesn't need to be perfect, it just needs to be good enough to avoid the worst.

12 comments:

  1. this is because we human are pessimist, the none pessimists was eaten by lions in the distant past

    http://thoughtsformykids.tumblr.com/post/27404491830/be-a-pessimist-or-die

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    1. This seems very silly to me. You see this explanation for literally every type of human behavior. People are pessimistic- oh that's because the optimists weren't looking out for lions. People are optimistic- oh that's because the optimists flourished as the pessimists were held back by their irrational fears (just look at Mr. Buffett, the successful eternal optimist).

      The fact is, people have free will and all this evolutionary garbage is a misguided attempt to apply our understanding of animals (who lack a conceptual faculty/free will) to humans. There are optimistic people, pessimistic people, rational people, irrational people, evil people, good people, etc. Not every human action is influenced by lions.

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  2. Can't remember when before I've been so captivated by an article.

    This part I found especially profound: "When we buy into companies or countries at high valuations we are implicitly betting that a best case scenario will unfold."

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  3. I would recommend Jared Diamond's excellent book "Collapse: how societies choose to fail or succeed". After reading it you wont lack examples of how it was possible to mess things up so bad that it got the whole population back to the stone age. It is also a very entertaining and well written book.

    There is a residual risk in all the equity investments. There is no way of knowing 100% sure that the books are not cooked, there is no big catastrophe waiting to happen etc. Many people spend extensive time discussing and analyzing scenarios, which can't really be analyzed.

    I tend to think that it is not really possible to analyze at the macro level. Many companies are already too complex for me to understand. Systems consisting of whole countries are indefinitely more complex. Worrying about macro developments is similar to worrying do I get cancer in 5 years. Worrying does not help you in any way or change the likelihood of getting cancer.

    There is lot more to downside than just low valuation. You need analyze what could go wrong and how much you could loose. Obviously, the reasonably likely scenarios are the interesting ones.

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    1. Arvosijoittaja,

      I'd heard of the book but never investigated it. I read a book titled In Search of Powder about the collapse of ski towns and they kept referencing the book Collapse.

      One book I enjoyed was When Money Dies which was about the hyper-inflation in Germany, Austria and Hungary around WWI.

      I think there's risk in every situation, not just equities, bonds anything. There's always something to worry about as well. I meant to call this out in the post, but I forgot when I was writing. Not many of us sit in buildings worrying about whether the roof will collapse, it's possible, but unlikely. Yet that risk always exists, it's never zero. I don't know if any risk can ever be eliminated, just minimized.

      I agree on macro events, there are too many moving pieces, even small companies are hard to analyze and predict because of the moving parts.

      Nate

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  4. Nate,

    great post, as always. I agree with averything, bth with regard to macro scenarios as well as on single company level.

    For me, those "end of world" fears on macro levels were always fertile hunting ground for interesting investments. When the news is full of "Italy and France will be bankrupt by the end of the year", then it is time to look at French and Italian companies.

    Same with Russia, Turkey etc.

    The best "hedge" against catastrophic outcome is some diversification. An investment can always go wrong, no matter how cheap or contrarian.


    mmi

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    1. mmi,

      I completely agree, when fear runs wild it's time to hunt. I recently picked up shares in two Russian ETF funds for that reason. There are some good individual deals, but it's too hard for me to buy individual stocks there, so it's fund time.

      As long as humans are present there's that optionality for good decisions, but also optionality for bad decisions as well, hence some level of diversification is needed.

      Great comment.

      Nate

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  5. (sry for my English from Sweden). The thought that society suddenly would collapse is nonsense. That we would suddenly end up killing our neighbours and wearing pelts is utterly riddiculous. However crisis do occur, that does not necessarily mean the end of the world. But Prem Watsa is probably right, China`s real estate market, economy and financial system will probably collapse in due time. The communist party will probably try and prevent this but it will surely get out of hand.
    Prem Watsa discussed a FEW of the signs in his latest fairfax holding annual report.

    "5. In almost every city Anne has visited, pretty much the whole existing housing stock has been replicated and is empty

    6. Home ownership rates in China are estimated to be over 100% versus 65% in the U.S. Many cities report ownership over 200%. Tangshan, near Beijing, is one.

    7. This real estate boom could only be financed through unrestrained credit growth. Since 2009, the Chinese banks have grown by the equivalent of the entire U.S. banking system or 15% of world GDP” (Prem Watsa, 2014, March 07 (annual), page 16)"

    Prem Watsa also has a good record of predicting major crashes. He predicted the crash of '87, the Japanese collapse of 1990 and the financial crisis. This is of course no guarantee but Chinas replication of the ENTIRE US banking system in 5 years is worrisome. Credit is a big source in most crashes historically.

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  6. Great article Nate. I believe "worst case scenario thinking" is just one of the costs of being human.

    I heard the China expert at the FFH dinner as well and I think her facts are correct, but I am not so sure about her conclusions. To use your analogy, Fairfax is betting on A=>B=>C=>D happening in rapid succession and not taking into account the changes to the equation that would happen, if different actions are taken at B and C than originally predicted.

    My read from the facts is that I do want to purchase homes in China with home ownership rates over 100%, but to go from that statement to predicting global market meltdowns is making a lot of assumptions and a bet that I will leave for someone else to make.

















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  7. Nice post Nate. Commenting on just the last couple paragraphs, I think that's right on--similar to the probability concepts that you discussed recently, which is how I like to think about various investments. What is the probability that X will occur? In just about every investment, there is usually some probability that something bad will occur that could damage your principal to some degree, but it's the probability that matters. Like the bank at 40% of TBV, there might be some chance it's worth its current valuation or less, but there is probably a much greater chance it's worth much more than its current valuation. And my very general observation is that even if there is only a 5% chance that it's worth less its current valuation, many people tend to focus on that well-known, but unlikely outcome. They focus so much on it that they overestimate the probability of the bad outcome.

    Anyhow, that's probably the same with the "prepper movement".

    I will say this about Fairfax, I've read Watsa's recent letters for the past few years along with the recent annual reports, and I think he's in a much different category than the doomsdayers (not that you put him in that category).

    Watsa is naturally an optimist I think, but he's very skeptical of the current situation. And regarding China, he had some very convincing evidence that the Chinese economy--specifically the real estate market--is in for some likely tough times ahead.

    Anyhow, great post.

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  8. Great article. Lots of people say that the end of cheap oil will kill civilisation, but wasn't theire a British empire before we used oil? Wasn't theire a rule of law in these times? We are far too advanced to return to the stone age, unless there's a nuclear war

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