Managing Uncertainty: Part 3
Here is something that caught our eye this week:
Part 3: Underwriting at Chenmark
So far in our series on managing uncertainty we have discussed the importance of taking an expected value based approach when making investment decisions and also covered why there are practical limits to a pure expected value methodology in the world of small business.
At Chenmark, we simply don’t know the magnitude of the payoffs or the true probabilities associated with the downside, base, and upside cases we underwrite. So, how should we think about moving forward, despite these limitations? To us there are three key things we should keep in mind:
One: Embrace uncertainty, but make sure we are compensated for it. We need to acknowledge that we aren’t going to know everything. We should certainly strive to obtain as much detail as we can and to build a comprehensive set of questions about any business we evaluate. But, disqualifying a lead based on incomplete information means shutting ourselves off to potential opportunity. Instead, we should be sure our operating assumptions build in a degree of conservatism that accommodates the lack of detail we possess. Seth Klarman, a notable hedge fund manager and author of Margin of Safety, has expressed this idea well:
“Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.”
Two: Understand the downside will happen. Be prepared to act anyway, and make sure we can structure deals to survive that outcome. As much as we don’t want it to, it is inevitable that some of our companies will struggle from time to time. The cause could be our own mis-management, could be a reflection of changing market dynamics, or could be some external factor that impacts the whole economy. Regardless, we need to be sure we can weather whatever storms come our way. This means structuring deals with downside protection as a top consideration, but appropriately calibrated for the tail scenario that it is. Our goal should not be to make tons of money in a downside scenario, but rather to ensure that if the downside comes to pass, we’ll live to fight another day. From Howard Marks on this theme:
“…Oaktree has always emphasized default avoidance as the route to outperformance in high yield bonds. Thus our default rate has consistently averaged just 1/3 of the universe default rate, and our risk-adjusted return has beaten the indices. But if we had insisted on – and designed compensation to demand – zero defaults, I’m sure we would have been too risk averse and our performance wouldn’t have been as good. As my partner Sheldon Stone puts it, ‘If you don’t have any defaults, you’re taking too little risk.’”
Three: Be open to upside surprises, but don’t rely on specific outcomes. While we spend a lot of time discussing and focusing on the downside, it is also important to think about the other side of the equation. At the individual transaction level, what we are looking to create is a highly asymmetric payoff profile where if we “lose”, it doesn’t create an existential issue and if we win, we enjoy a terrific outcome. Thinking more broadly, building an entire collection of businesses / deal structures with this type of profile has the potential to deliver explosive if unpredictable growth.
Importantly, this randomness can be disarming. In the same way we are drawn to certainty and precision in predicting downside, so too are we tempted to lay out a specific path for future growth. We naturally want to know exactly where we are going, and while we certainly can have plans for the future, preparation and exposure are more important than a detailed roadmap.
In sum, we want to structure investments where we can be sure an appropriately underwritten downside is something we can tolerate, and we want to accumulate exposure to asymmetric upside.
In next week’s final installment of this series, we’ll discuss the factors intrinsic to Chenmark that can help reinforce this risk / reward dynamic and compare our strategy to other popular alternatives.
Have a great week,
Your Chenmark Team