Pandemic Investing: Insights and Lessons

Nov 10, 2020

As investors, we have different triggers for behaviour and frame narratives that shape our investing decisions. This can work for us, or against us.

At the Morningstar Investment Conference, professor Sanjay Bakshi addressed this by drawing parallels between evolutionary biology and investing and capitalism.

Here is a summary of his perspectives.

K-T was a Black Swan event.

The Cretaceous-Tertiary extinction event, or the K-T event, is the name given to the mass extinction of dinosaurs and other species that took place around 66 million years ago.

A humungous asteroid or meteor slammed into the earth and the world changed in an instant. The collision was equivalent to several million nuclear weapons detonating simultaneously, triggering geologic disturbances such as earthquakes, landslides, tsunamis and fires.

The K-T impact wiped out almost 90% of land-based species but only 10% of those living in fresh water. Water obviously offered protection against heat and flame. All the land-based animals that survived had a habit of retreating to a safer environment during times of danger—into water or underground—either of which would have provided considerable shelter against the ravages of climate change following the impact. - A short history of nearly everything by Bill Bryson).

Our mammalian ancestors lived underground. Over the next 100 million years, they emerged and burst forth in profusion. We all are their descendants.

There are negative Black Swan events and positive Black Swan events.

We are so acquainted with our notion of inevitability as the dominant species that we find it hard to grasp that we are here because of a catastrophe that happened to a dominant species millions of years ago.

K-T was disastrous for the dinosaurs and 90% of the land-based species (negative Black Swan), but good for us (positive Black Swan).

Nature is not cruel, only pitilessly indifferent. This is one of the hardest lessons for humans to learn. – Richard Dawkins

Same with capitalism.

If you fight the change, you could go extinct.

Over 5 billion species that ever lived on earth have gone extinct. Survival is the exception. Extinction is the norm. Adaptation is a must.

When Black Swan events occur, there will be death and destruction and extinction. The pandemic has caused massive job and revenue losses in the travel and tourism industry. But there will also be new life and emergence of new species. Zoom has witnessed explosive growth as the most accessible video conferencing service.

In destruction there is creation.

Companies will need to adapt to the environment. There will be cost cutting, retrenchments, letting go of office space, curbing travel - basically doing the same amount of business with less. Frugality is of essence. Costs that were created during good times but deemed unnecessary during a slowdown.

Look around – there are plenty of entrepreneurs who took risks that will not pay off. Just like nature, capitalism ruthlessly eliminates those who are no longer fit for their environment.

You cannot be untouched.

It is impossible for many businesses and investors to avoid the impact of a negative Black Swan.

A business owner may assume he is unthreatened because of a diversified customer base and has no customer concentration risk. How safe would he be if all his customers disappear for a prolonged period of time while the costs stay intact? Think about movie theatres, theme parks, restaurants, gyms and airlines.

An investor may have a well-diversified portfolio. But that won’t protect him in a prolonged economic depression caused by the impact of a negative Black Swan.

Business and Investing is a pari mutuel game.

When you play roulette, you are betting against the house. No matter what the other players do, your odds are unaffected. That is not a pari mutuel game.

In a pari mutuel scenario, the behaviour of other players changes the odds.

Take the example of a cyclical industry that is in the middle of a downturn. Company A has the lowest cost and a liquid balance sheet. He refused to expand recklessly during the boom times. That creates anti-fragility for Company A. He is now in a position to buy out businesses during the downturn at a very low valuation and reduce his competition. The past (foolish) behaviour of other players changed the odds of success for this smart player.

In the world of investing, the foolish behaviour of some investors changes the odds. If a business is valued much more highly than what its fair value should be, then clearly for investors forward returns go down. It’s no longer as attractive as it was earlier. Similarly, if the market brings down the valuation of a solid business to a low, as compared to its fair value, the future odds of success improve.

Lessons in survival: Reduce exposure to negative Black Swans

  • Have a strong balance sheet: Low levels of debt, little or no asset-liability mismatch, cash on hand to meet expenses when income is insufficient or absent.
  • Seek diversity: Multiple streams of earnings with little or no correlation with each other.
  • Reduce dependencies: Dependence makes the system fragile. The more dependent you are on external factors, the more fragile you are.

Lessons in survival: Increase exposure to positive Black Swans

  • Hold cash for opportunistic reasons: For this, you must understand the option value of cash. Cash is an asset which does not earn much but has a huge option value because of volatility. The more the volatility in an option-pricing model, the more the value of the option – call or put. The option value of cash is high because the world is a volatile place. In the world of investing, having cash enables you to buy bargains when they are available. (Read more of that concept here).
  • Have a contrarian mindset and act when opportunity arises. Once in a while there will be a Black Swan event that will result in a market crash as people believe the world, as they know it, is coming to an end. You have a choice whether or not to go with historical evidence about panic and fear during downturns, or believe that this time it is different. My advice is to go with history. If you are wrong and it is indeed the end of the world, then it would not matter anyway. If you are right, then you should do extremely well.
  • To survive and thrive in the long run, you have to suffer in the short term. For many, it is too expensive a cost. You must be willing to look foolish, as long as you don’t act foolishly. The cost of holding cash in a prolonged bull market is well known to investors. Businesses holding cash for prolonged periods of time, see their RoE pulled down.

Understand that we don't know the future. Investors do better where risk management is a conscious part of the process. Survival is the only road to riches. Try to maximize return only if losses don't threaten your survival. - Peter Bernstein

Investment Involves Risk of Loss.

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