Managing Uncertainty: Part 2
Here is something that caught our eye this week:
Part 2: Applying Theory to Practice
Last week, we went over some first principles concepts related to risk and uncertainty. The core idea was that if you have a strong understanding of the range of outcomes, the probabilities associated with those outcomes, and your ability to tolerate a negative result, you should consistently make positive expected value investments. This may be difficult to execute, especially if you encounter a string of disappointing but statistically possible negative results. However, a disciplined focus on process over outcome, and on maintaining sufficient capitalization, will result in strong results over the long term.
Much of this theory is relevant when applied to Chenmark, but there are some very important practical differences. First, while we base most of our underwriting on a range of potential outcomes and associated probabilities, the reality is that we have very little certainty about any of these inputs, especially when compared to games with constraints. If you have a flush draw in poker for example, you can determine your odds of landing another card of the right suit, and you can determine your cost to call relative to the overall pot, and arrive at a fairly strong sense of expected value. You may not win, but your understanding of the bet you are making is quite thorough. On the other hand, in the small business world, we don’t truly “know” any of this information. We do the best we can with the information we have, but our understanding of expected value is always going to be fuzzy at best.
The second big practical difference when applying theory to practice involves agency. In short, we get to have an impact on the eventual outcomes and on their probabilities. Going back to our poker example, you may understand your odds with complete clarity, but there is nothing you can do to prevent a heart from falling if you really need a spade. On the contrary, when we buy a small business, the quality of our subsequent management will meaningfully change the trajectory of the company. Done well, this should be a significant advantage for us.
The final practical consideration when applying theory to practice in this area has to do with bet sizing. There has been significant research devoted to optimizing the equation for sizing a bet relative to one’s overall capital. Unfortunately, a lot of this math depends on a clear understanding of expected value (see the first point above). In addition, the formula doesn’t account for the constraints of specific investors. For us, our limited capital and target company profile mean that we are consistently placing large bets relative to our overall capacity. While that percentage of equity capital allocated to each deal will likely fall over time, the size of the commitment does impact our tolerance for negative outcomes.
Yogi Berra is famous for noting that “In theory there is no difference between theory and practice – in practice there is”. It is easy to talk about investing theory and uncertainty in the abstract, but as we often say around here, being in the arena is different. We must always be mindful of the ways in which our reality creates differences from the norm, both positive and negative, and use those circumstances to our advantage.
Next week, we’ll go one step further and focus on how both theory and practice come together to form a capital allocation strategy for Chenmark, and also take a look at how ours differs from other popular models.
Have a great week,
Your Chenmark Team