Portfolio manager’s Letter January – Febuary 2013
Nassim Nicholas Taleb’s personality is hard to describe. Suffice it to say that he is arrogant, obnoxious, and intolerant, and he loves to make simple things complicated. In spite of the fact that his sparkling personality shines through on practically every page of his new book, “Antifragile” is an important work, and may well be, as he claims, a more important book than “The Black Swan”, which he wrote in 2007. In a sick way, the book can be quite funny, and in my opinion, it is a must read for anyone with skin in this game of investing.
Lacking the stomach to wade through Taleb’s thick prose, an investor should at least gain a basic understanding of what he means by “Antifragile”. It is, after all, exactly what you want the companies you invest in to be. Taleb’s point is that the future is unpredictable, and since Black Swans are inevitable, any system, company, country, or organism (human or non) that is to last, must be antifragile.
Taleb does not discuss it in his book, but I think that this concept will be a very useful tool in investment management because it helps you understand those characteristics that allow a company not to just survive a Black Swan but become stronger because of it. The subtitle of the book is “things that gain from disorder”.
Robust is not antifragile, what is robust survives the crash, but what is antifragile does not just survive – it benefits from the disorder. Chapter 4 is titled “What Kills Me Makes Others stronger” the antifragility (survival) of some comes at the expense (failure, death) of others. This is key, for a system or company to be antifragile it must gain from the mistakes of members that fail.
From the investors point of view I think now it is a very interesting time to find good stocks. Having just experienced a generational Black Swan we now know who the survivors are. Of course, as Taleb points out, the trick is not to just survive, but to have benefited from the Black Swan. It is time now to look for other companies and industries that have gained competitive position.
It may be a little early to tell who will be the long term winners for banks for banks, other financial stocks, and thing related home building, but it is time to start comparing current earnings of specific companies to their peak earnings in 2007 in order to see who has picked up a competitive advantage.
In business this is easy to understand. You want to own companies that get better in a period of stress. This means their management is able to learn from their mistakes or even better is able to learn from the mistakes of their competition. Of course to learn you have to survive, so you have to start with a bullet proof balance sheet.
Warren Buffett understood antifragile long before he received the benefit of Taleb’s explanation, and Berkshire Hathaway is probably the best example we have of what an antifragile Business should look like. Instead of consolidating his subsidiaries under central management in the name of economies of scale Warren Buffett keeps existing management in place to build diversity, and to avoid the fragility that gets built into most very large companies. It is highly unlikely that all 140 managements are going to make the same mistake at the wrong time.
Add to this Berkshire Hathaway’s huge pile of cash, and the cash flow from its subsidiaries. Warren Buffett has designed his company not to just survive a black swan, but to get stronger because of it. No better example of exactly what antifragile means can be seen than Warren Buffett’s work since the 2008 crash Warren Buffett has written the book on how to benefit from black swans. Berkshire Hathaway was built with the philosophy that large unpredictable events will happen.
Rather than trying to predict the future Warren Buffett builds his business to withstand the unpredictable. The central point of antifragile is not complicated, but is that the best lessons we learn, we learn from our mistakes. A fragile person, business, or country is one that does not learn from their mistakes, or better yet from the competition’s mistakes.
Everything that is fragile eventually fails. Concentration and large size makes a business fragile. For example a banking system with five very large banks is a fragile (highly exposed to a Black Swan) because the failure of one big bank can bring down the whole system. A system of the same size with 200 medium and small sized banks is antifragile because the failure a few banks will not do serious damage the system, the system as a whole will get stronger with the lessons learned from the failures.
A free market economy is antifragile. Socialism is fragile. While not specifically mentioned there are in Taleb’s book some important lessons for politicians and central bankers. It is popular with these groups to believe they have the power and duty to relieve human suffering caused economic Volatility. The problem is, the politicians, or economists have no better power to predict the future than anyone else, and they are almost always unwilling to acknowledge the reality of, let alone take responsibility for, the unintended consequences of their actions.
The regulators and legislators are subject to the same psychological problems as the business and bankers. Thus while their intentions maybe only to help they have only the power to delay, when their intervention is successful any delay they purchase is likely to increase the cost of the of the next crisis.
Alan Greenspan and the FED spent the 1990’s trying to eliminate economic volatility (the 1994 soft landing, the LTCM bailout) yet every time the FED acted to prevent pain they succeeded in making the economy more fragile. What they really are prolonging are the conditions that promote foolish behavior.
I have written several times about the importance of the business cycle, specifically in the February 2012 investment manager’s letter “Learning from pain“. Were we pointed out that the instability of our economic system is considered by most economists to be unfortunate. This in turn leads to the rather silly assumption that it is the legitimate function of government to design a painless system. Our conclusion was that rather than a problem that needs to be fixed, it is this instability that makes our economic system work. Indeed it is Taleb’s contention is that instability makes our economy stronger (more antifragile).
More recently in October 2012 investment manager’s letter “This Time its Different“. We found information from tables in the excellent 2009 book of this name written by two professors from Harvard, Carmen M. Reinhart and Kenneth S. Rogoff.
These tables show that the United States has experienced 13 banking crises since 1800, and not only survived but prospered, while Russia, Kenya, Angola, Hungry have had two, Romania, Angola, Algeria, and Zimbabwe, one. It is time to look at the business cycle as a natural function of a market economy. While we may not like the pain of the consolidation, it is helping the system to grow and remain dynamic.
Capitalism is inherently unstable, periods of economic stability encourage bankers and businessmen to accept ever increasing risks, they do so partially to stay competitive “as long as the music is playing you have keep dancing”, but also because the longer a period of prosperity lasts the more the collective memory of market participants loses touch with the last bear market.
Taleb says that it is instability that makes an economic system antifragile, if Taleb is right, and I think he is, it is the business cycle, and the hard lessons that trail in the wake of the economy that has gone off a cliff, that make capitalism strong and dynamic. A crash provides a nice ego haircut for those egos most in need of a trim, and also provides a reliable antidote to the terminal arrogance that is a part of the human condition at the top of a bull market.
Nothing raises the risk of bad behavior more than a long period of prosperity. Governmental interventions to moderate the swings only serve to anesthetize the participants, thereby prolonging and increasing the damage they are inflicting on their economy.