“Minimizing downside risk while maximizing the upside is a powerful concept.” – Mohnish Pabrai
Dear Friends and Family,
What is your investing goal?
Everyone should have an investing goal, one that suits their particular situation. If you went to a run-of-the-mill investment advisor they might outline three common goals including capital appreciation, current income, and capital preservation. These terms are helpful, but we think they present a false choice. Our goal is positive skew, and the resulting strategy seems to provide better capital appreciation over the long term and safer capital preservation.
In this letter we summarize the common financial goals, some criticisms, and why we seek positive skew.
The Three Common Financial Goals
Let us first review these three common investing goals...
Capital appreciation seeks long-term growth. In practice this typically means investing in stocks for many years and reinvesting the dividends. Capital appreciation accepts higher day-to-day price fluctuations in favor of achieving a higher overall return over a longer period of time. Younger investors, and those wealthy enough to absorb large losses, are commonly advised to take a capital appreciation approach.
Current income seeks investments that pay out high cash flows. These typically include stocks that pay a consistent and high dividend, high quality real estate investment trusts (REITs), investment grade bonds. In practice, current income is thought to reduce risk by creating more predictable cash flow. This might be the case, but it might not. Consistency of historical cash flows does not guarantee safety...but it can create the illusion of safety. Investors living off their retirement savings are often inclined to pursue a current income approach because they may feel that it is easier to gauge the adequacy of their nest egg by whether the cash flows generated are sufficient to cover expenses.
Capital preservation seeks to avoid losses. In practice, this often means keeping money in the bank, CDs, Treasury Bills, and other assets that are believed to be very low risk. Investors that cannot afford to take a hit, such as the retired that would need to reduce spending if they lost wealth, are more inclined to take a capital preservation approach. They are seeking safety, acknowledging that this probably means giving up potential return. Whether they actually achieve safety depends a lot on the future path of inflation which can erode the purchasing power of savings.
The three goals above are useful for communicating, but all seem lacking.
For example, suppose someone wants to “preserve capital” today. Interest rates on savings accounts and short term treasury bonds are near zero. Inflation has been very low for the past ten years, but if 20% of the workforce continues to get helicopter money without contributing to our means of production, there is a good chance we get much higher inflation.
How does one “preserve capital” when presumably “low risk” investments earn far less than inflation?
There is no good answer to this question. No portfolio can “preserve capital” in this environment without taking on risk. We can accept negative real rates of return by keeping our money in short term CDs that earn less than inflation, but over time we will lose purchasing power.
What if our goal is to “Capital Appreciation”...does that mean we put nearly all our money in the stock market and ignore it for twenty years?
That appears to be what most money managers believe. Target retirement accounts with longer time horizons often cite “Capital Appreciation” as the goal...and these funds commonly have >80% exposure to stocks. But investors in Japan can attest to stocks losing over long periods. The Japanese stock market has not hit a new all-time-high in over 30 years!
One reason why investing in the S&P 500 is often considered the default investing strategy for young people is because it has been the best performing stock market in history, but that is some serious cherry picking. Many stock markets have collapsed since the first IPO. I’m not suggesting that the S&P 500 is going to collapse...my point is that how investors expect to appreciate their capital depends a lot on recent history.
In China for example, many investors believe that real estate is the best way to appreciate capital. Stocks are often shunned as “speculation” and the best way to increase “current income” is to start your own business. Why is it so different here? How will implementing these goals change if the housing market collapses and the stock market booms?
At least “capital appreciation” and “capital preservation” are clearly defined. The former wants to increase wealth, the latter seeks to avoid losses. What are “current income” investors trying to achieve?
I’ll explain with an example. Suppose you are invested in a stable “blue-chip” company called XYZ because it pays a consistent 3% dividend. Then XYZ temporarily suspends their dividend because they need the money to build a new factory in order to satisfy higher than expected demand.
Should a “current income” investor sell XYZ?
Technically yes...but for reasons that are clearly nonsensical. Without a dividend, XYZ provides no “income” but it’s now a more valuable company and so an investor can just as easily sell some shares to make up for the dividend cut. There is no logical reason why retired investors should prefer getting paid in dividends, coupons, or price appreciation. As Ford investors recently learned...historically consistent dividends create the illusion of safety, but not actual safety. Premiums for investments that produce higher cash flow tell us more about human psychology than they do about intrinsic value.
We often decide between two options based on the expected outcome. Say you go to a new restaurant and are choosing between pasta and brisket. You like brisket so you go with that. But it is hard to make brisket well and so you might end up going hungry. Perhaps you should have gone with the pasta…it’s really hard to screw up pasta.
Positive skew is that there is a bigger chance of a large loss than a large gain. Brisket, in this example, may provide you with a higher expected return (better tasting), but carries a greater risk of (but easier to screw up). The best decision makers are those that learn to think in terms of probabilities. This is true with dinner, investing and perhaps even politics. The best decisions are those that avoid “tail risks” and allow for potentially very positive outcomes.
In investing...positive skew is a rare property. The company, commodity, or currency needs to provide very little downside risk compared to the potential gain.
Options provide artificial positive skew. An option gives the holder (long position) the right, but not the obligation, to purchase a financial asset at a given price. If the price moves against you then the most you can lose is the cost of the option, but gains are limited only by how far the price can move in the money. Option traders know this and so option buyers on the whole are required to pay large premiums to compensate sellers for the negative skew they are taking. But assets can also exhibit natural positive skew, and that is what we look for.
So where does one search for natural positive skew?
In truth the return distribution (i.e. probability of gains and losses) is unknowable. Much in the world of finance is determined by “radical uncertainty” in the words of Mervyn King. What this means is that not only do we not know what the future will bring, but that we generally cannot put probabilities on future states of the world.
But if we put enough time and effort into understanding an investment we can at least try to get a good sense for the range of potential outcomes.
For example, last year we made a big bet on Tesla. We shared a 33 paper about why we were making the investment with about fifty friends and family. It was the only investment that we shared publicly the whole year. The kids helped do the research and one of our YouTube videos even went viral getting over a million impressions.
We don’t do “price targets”. No one knows the “intrinsic value” of any asset. That’s the trap that “current income” investors fall into … they want certainty in how much money they will receive even though certainly in investing is always an illusion. This is especially true for a stock like Tesla that’s subject to so many unknowns that most would agree that it’s true value is unknowable.
What we did find is that there was a good chance that Tesla would be successful in becoming profitable in the near term, and that its rapidly falling costs paired with rapidly rising adoption provided the path toward a significantly higher valuation. Within a few months the stock price went up 500%, before falling about 50% during the current Recession. Will Tesla go bankrupt? It could happen! Or maybe their competitors will and Tesla becomes the world’s dominant car company. Or maybe something in between.
We also invested in a friend’s tech startup. We did not attempt to value his company. When we invested he didn’t have much more than an idea and some code. We invested in him … because we know him to be diligent, very hardworking, trustworthy. Will he fail? Most likely...but then there is a chance we get a major windfall from his IPO ten years from now.
Our portfolio contains many investments that we believe to have the quality of positive skew. The result is a portfolio distribution with the same shape (blue). In any given year we try to expose ourselves to the potential for large positive returns by accepting a modest reduction in our worst case scenario. Maybe none of our risky investments will payout, and if so we will end up with a lower return than a typical portfolio (red). We like that tradeoff.