Time arbitrage and risk
In Quench Your Own Thirst: Business Lessons Learned Over a Beer or Two Jim Kock, founder of the Boston Beer Company, the one behind Samuel Adams, beautifully describes his decision to leave a very promising and almost certain career path with the Boston Consulting Group to launch a small brewer, in 1984, decades before doing so became trendy and easy. People called him crazy, saying it was an irrational and risky move. He reasoned the opposite: risky would be to commit his life to a career path he did not enjoy in exchange of better financial visibility in the near term at a moment when he did not need it at all. People saving and investing spare money should think alike.
As we do not want this piece to enter specific and polemic discussions about individual assets, let me describe two pools of assets to illustrate my point, leaving it with your imagination to bring up examples:
Pool 1: Companies and sectors in secular decline and/or facing tough headwinds from social, environmental, or competitive forces.
Pool 2: The opposite. Things in sync with how the future is being shaped.
Because many assets from Pool 1 are forgotten corners of an obviously exuberant market right now, many see them as cheap and safe investments. For us this is shortsighted – with the caveat that exceptions exist for any such broad-based statements.
We would much rather run the “risk” of seeing a temporary 30% drop in our investments’ market value in the short run with high odds of outperforming the broad market over ten years than get into something with little or even zero short-term probability of loss but almost certainty of underperformance in the long run, probably to a large degree. Risk is not volatility in this mindset. Risk is the probability of losing purchasing power or wealth in relative terms in the long-term. By arbitrating time better than others we can lower actual risk for our partners and clients. In other words, by changing the timescale of our thoughts, like Jim Kock did, we not only decrease the likelihood of negative, irreversible outcomes, but also increase the odds of finding ourselves in positive, convex situations.
I can hear many readers’ counter argument: you should stay in the “safe” assets for now and jump ships when the 30% drop comes. For those with a crystal ball, go ahead. We do not have one. That said, we are not arguing for investments whose valuations are out of touch with reality (but observing that in some cases “reality” means high odds of exponential and profitable growth), much less so in trendy companies with no moat. Moreover, our “ten-year” approach also leads us into areas broadly seen as safe harbors, such as fixed and wireless broadband providers, which are durable, predictable, and growing businesses because they own the infrastructure of the digital age, as well as direct customer relationships, or Amazon, which owns other two important pieces of such infrastructure in cloud computing and physical assets operated by code to power e-commerce at scale, not to mention the millions of Prime households. These companies represent about 50% of our portfolio today and seem overlooked relatively to most of the market. Nonetheless, we also see many highly coveted companies from Pool 2 as low-risk (even if not great) investments right now.
Investors and capital allocators may also, wisely, want to hold some option value for the event of a downturn, the ultimate form of doing so is to sit on some cash - remember though that cash is an extremely risky asset in the long-term. Within our fund, our more predictable holdings just mentioned should fill this “option-value” role, even if imperfectly, while compounding per-share intrinsic value at double-digit rates. The higher valuations go overall, the more valuable this option gets.
To close, something is or isn’t risky because others, even if they are “specialists”, tell you so. It is or isn’t depending on what is a negative outcome to you, as well as your fact-based judgment over probabilities and severity. If this sounds like one of my favorite passages from Warren Buffett, it is not a coincidence. From his 1964 letter to investors:
"It is unquestionably true that the investment companies have their money more conventionally invested than we do. To many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional nor an unconventional approach, per se, is conservative. Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meetings of the Flat Earth Society."
Tarpon U.S. Equities
February 21, 2021