Written by Alex Hughes, International Analyst
Article first published in StocksInValue
Last week, I got to work nearly 2 hours late. This gave me a lot of time to think (mostly about how I would explain my tardiness to my boss!). As I sat in gridlock, it dawned on me how powerful the principle of asymmetry is, the same principle that disrupted my morning and is perhaps the most underrated principle in investing.
I live in Manly NSW and our offices are in Sydney CBD – which means I must run the Military Rd gauntlet to get to work, a stretch of road where the travel time is very sensitive to slight changes in the number of road users. The following equation, inspired by the thinking of Nassim Taleb, does a good job of explaining my morning:
15% increase in the number of cars on the road (due to 5mm of rain) = 300% increase in total travel time.
From the equation above, we can see that the increase in travel time was highly asymmetric to the increase in road users. As I learned the hard way, the trick is to have asymmetry working for you and not against you. Positive asymmetry is the key, where the potential upside dwarves the potential downside.
Asymmetry can be found in many areas, from the earnings power of businesses to the return profile of stocks and even the success of political candidates.
Despite their popularity with Australian investors, the earnings power of a bank is subject to negatively asymmetric forces. Just consider that the upside from making a loan is receiving all of the interest while the downside is having the entire principal not be repaid. As a result, there have been numerous occasions throughout history where the cumulative profits ever made across the entire banking industry have been lost in a single year. Just like “picking up pennies in front of a steam roller”, the gains that are made are minuscule in comparison to the potential downside risk.
Figure 1. Royal Bank of Scotland’s earnings
On the other hand, software companies can be an example of the complete opposite. Just consider that Microsoft developed Windows once, yet was able to sell essentially the exact same product to millions of different consumers, an asymmetric return achieved on the fixed investment in IP. And unlike banks, there is no single event that could bring Microsoft to its knees. The distribution of stock returns in general is also highly asymmetric.
Figure 2. Distributions of NYSE, AMX and NSADAQ stock returns, 1983-2006
In investing, everyone’s goal should be to incorporate as much positive asymmetry into their portfolios as possible. This should start with a negative screen by avoiding those with a high degree of catastrophic risk, and by paying prices low enough to allow for asymmetric payoffs. There are a number of ways to work towards this. Perhaps the most powerful is with informational advantages.The rise of Donald Trump as a presidential candidate also has some asymmetric properties. By running, the Donald exposes himself to the potential upside of winning, shared by all candidates, however his position as a media personality ensures he does not have the same downside from losing, as he benefits significantly more from the publicity than the other candidates. Just like how a scandal hurts a politician but benefits a rockstar, the Donald has asymmetry working in his favour.
Stock prices change as new information is incorporated into the share price, so having unique or superior insights compared to other market participants is key. The area where you have the greatest chance of doing so is in small-caps, as analyst coverage is the thinnest, creating the possibility of finding stocks where little of the future potential is factored into today’s price. Investors dramatically increase their probability of success when their knowledge of the asset greatly exceeds that of the seller.
Conversely, the area where this is hardest is in widely covered large-caps, as it is very difficult to identify new information about a business that hasn’t already been dissected by 20 analysts. IPO’s also fall into this category as the seller knows vastly more about the business than the buyer could ever hope to, and this information asymmetry has almost certainly influenced the timing of the sale. Remember Platinum Asset Management’s IPO at the top of the equity market in 2007, or McGrath Ltd’s IPO today?
Positive asymmetry can also be achieved by identifying situations where the expectations of investors are misaligned with reality. Howard Marks once said “If I were asked to name just one way to figure out whether something’s a bargain or not, it would be through assessing how much optimism is incorporated in its price.”. This statement has always resonated with me as it encapsulates the entire value investing framework. Stocks that are priced to perfection can have inbuilt negative asymmetry, as if results fall short of expectations, they are likely to whiplash significantly lower. Conversely, as a business becomes more overlooked, it often becomes safer.
To give a current example of a highly asymmetric situation, New Guinea Energy (ASX:NGE) springs to mind. NGE is a $16.9m capped company with $19.9m of net cash, giving a high level of downside protection to today’s buyer. In addition to its cash balance, it also has a series of oil and gas assets that it is seeking to monetise. Its most interesting asset is potential earn out payments which could deliver $28m USD of cash plus an unlimited production-based royalty if Exxon Mobil and Oil Search have success with the assets (article available on StocksInValue). In my opinion, this is a highly asymmetric situation, as the potential value is high in a best case situation, however the net cash balance and plethora of other assets suggest the potential downside is very minimal. Further, it is likely to benefit from higher oil prices disproportionately more than it is impacted by lower oil prices.
When one adopts an investment approach focused on asymmetry, which by nature means focusing on limiting the potential downside, it opens the possibility of achieving asymmetric results over time.
Figure 3 (below) is taken from an internal small-cap model portfolio we have been running since November. We hope it will progress into a new product for interested clients in the not too distant future. Pleasingly, the results have been asymmetric on two fronts, with the number of winners (horizontal) greatly outnumbering the losers, and the profits from the winners (vertical) greatly exceeding the losses from the losers; dual forces of positive asymmetry in action.
Figure 3. Stock picks from our internal small-cap model
Source: Clime Asset Management
Disclosure: Alex Hughes owns shares in New Guinea Energy.