Weekly Thoughts


Managing Uncertainty: Part 1

Here is something that caught our eye this week:

Part 1: Range of Outcomes

The last few months, we have spent quite a bit of time discussing potential acquisitions or deal underwriting more generally.  While each of these conversations tends to focus on the idiosyncrasies of the company being evaluated, conceptually speaking, we are engaging in a form of betting exercise, where our challenge is to make the best possible decision despite having limited information and a high degree of uncertainty.  We were reminded of this idea when listening to professional poker player Caspar Berry deliver a Ted Talk on the topic, which we’ll use as a jumping off point for a deeper dive over the next few weeks.

Our focus this week, the first of a four part series on managing uncertainty, is on first principles.  While the whole Ted Talk linked above is worth the 20 min time investment, the key idea is that the world is an inherently complex and uncertain place, and attempting to fully eliminate risk or to drive for “certainty” is unrealistic.  Instead, we must do our best to understand the full range of potential outcomes and use that information to think probabilistically about expected value.  We must try to understand what happens if we are right, what happens if we are wrong, and the probabilities associated with those outcomes.  Betting math is a simple way to illustrate this idea.  Assume there is a pot worth $1000 that requires a $100 buy in to win.  If there is a 20% chance of winning, we end up with a $120 expected value: (20% * 1000) – (80%*100) = 120.   The expected value of 120 divided by the upfront cost of 100 implies a long term return on investment of 120%.  Think about that in Free Cash Flow yield terms.  Pretty compelling.

So the math would indicate we should take this bet all day long.  Now, think about the lived experience of that choice.  While the expected value of the bet is 120, this is simply a representation of the average of all the outcomes over many iterations of the game.  You will never actually win 120, you will either win $1000 (great), or, more frequently, you will lose $100 (not so great).  That’s easy to accept in writing, but much harder in practice.  We have people who get upset when picked multiple times by the lunch bot when the odds of selection are somewhere around 10%.  How would it feel if you lost $100 for what in some stretches would certainly be days or weeks on end?

The difference between lived experience and rational math is one key reason why betting, investing, or any risk based exercise is hard.  To manage our way through, there are two key takeaways.  First, we must concentrate on process over outcome.   And second, we must understand and be comfortable with the consequences of the negative outcome.  From the 25iq blog titled A Dozen Lessons about Business and Investing from Poker:

“[A baseball executive] was in Las Vegas sitting next to a guy who has got a 17. So the dealer is asking for hits and everybody knows the standard in blackjack is that you sit on a 17. The guy asked for a hit. The dealer flips over 4, makes the man’s hand, right, and the dealer sort of smiles and says, “Nice hit, sir?”  Well, you’re thinking nice hit if you’re the casino, because if that guy does that a hundred times, obviously the casino is going to take it the bulk of the time. But in that one particular instance: bad process, good outcome. If the process is the key thing that you focus on, and if you do it properly, over time the outcomes will ultimately take care of themselves. In the short run, however, randomness just takes over, and even a good process may lead to bad outcomes. And if that’s the case: You pick yourself up. You dust yourself off. You make sure you have capital to trade the next day, and you go back at it.”

Next week, we’ll continue this discussion and apply some of these concepts to Chenmark’s activities in the small business acquisition space more directly.

Have a great week,

Your Chenmark Team

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