Cigar Butts, Debt, and Black Swans

I've been reading a couple books by Nassim Taleb, specifically The Black Swan and Antifragile. I've also been reading The Success Equation by Michael Mauboussin. These books have made me think about how an improbable, extreme outcome that no one can predict -- a Black Swan -- impacts investing strategies.

Citing Taleb’s theory, in The Success Equation Mauboussin says that when you’re working in a field that sometimes has improbable and extreme outcomes, it's better to regularly buy low cost options that allow you to reap a large, one time Black Swan profit than it is to sell options that generate small, recurring profits but leave you exposed to a large, one time Black Swan loss.

If you're a Graham-style value investor buying a low multiple, cigar butt stock, your two improbable, extreme outcomes are: (1) bankruptcy or (2) the company's unexpected return to high growth. The interesting point is that if you buy a low multiple stock with little or no debt and plenty of working capital, then you can dramatically reduce the odds of a Black Swan bankruptcy while still preserving the buyer’s option you purchased on unexpected growth. Consistent with Mauboussin's advice, a diversified portfolio of low multiple, low debt stocks are like buyer options with limited bankruptcy risk and the possibility of large, one time profits from unexpected growth or other good news (like a buyout offer).

If you’re a growth stock investor buying high multiple stocks, then your two improbable, extreme outcomes are: (1) much higher growth than what's occurred in the past or (2) negative, declining growth. The problem is that the Black Swan risk of negative, declining growth can't be eliminated.

Black Swans, and the need to factor them into your investing strategy, remind me of a J.R.R. Tolkien quote my father, who was in the construction business, had on his office wall:

"It does not do to leave a live dragon out of your calculations, if you live near him."

Black Swans and big negative outcomes also remind me of the importance of avoiding investing losses. It's easy to forget that investing performance is impacted by both gains and losses.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice.