Category Archives: Special Situations

On the day when I left home to make my way in the world, my daddy took me to one side, “Son,” my daddy says to me, “I am sorry I am not able to bankroll you to a large start, but not having the necessary lettuce to get you rolling, instead I’m going to stake you to some very valuable advice. One of these days in your travels, a guy is going to show you a brand-new deck of cards on which the seal is not yet broken. Then this guy is going to offer to bet you that he can make the jack of spades jump out of this brand-new deck of cards and squirt cider in your ear. But, son, do not accept this bet, because as sure as you stand there, you are going to wind up with an ear full of cider.” –Sky Masterson

The Unknown and Unknowable

From David Ricardo making a fortune buying British government bonds on the eve of the Battle of Waterloo to Warren Buffett selling insurance to the California earthquake authority, the wisest investors have earned extraordinary returns by investing in the unknown and the unknowable (UU). But they have done so on a reasoned, sensible basis. The acronym UU refers to situation where both the identity of possible future states of the world as well as their probabilities are unknown and unknowable.

This article may take several readings but you will find that your investing can vastly improve if you understand how to distinguish risk from uncertainty. Click on link here: Investing_in_Unknown_and_Unknowable_Zeckhauser

An EXCELLENT article for advanced investors.

Zeckhauser’s Approach

(from Sanjay Bakshi) Let’s keep this idea – of seeking exposure to positive black swans in mind, and move on to Richard Zeckhauser whose famous essay “Investing in the Unknown and Unknowable”

(http://hvrd.me/b87ESq) is a must-read for all investors.

In this essay, Zeckhauser discusses a few critical things. Let me just list them out.

First, most investors can’t tell the difference between risk and uncertainty.

Risk, as you know from Buffett, is the probability of permanent loss of capital, while uncertainty is the sheer unpredictability of situations when the ranges of outcome are very wide. Take the example of oil prices. Oil has seen US$ 140 a barrel and US$ 40 a barrel in less than a decade. The value of an oil exploration company when oil is at US$ 140 is vastly higher than when it is at US$ 40. This is what we call as wide ranges of outcome.

In such situations, it’s foolish to use “scenario analysis” and come up with estimates like base case US$ 90, probability 60%, optimistic case US$ 140, probability 10%, and pessimistic case US$ 40, probability 30% and come up with weighted average price of US$ 80 and then estimate the value of the stock. That’s the functional equivalent of a man who drowns in a river that is, on an average, only 4 feet deep even though he’s 5 feet tall. He forgot that the range of depth is between 2 and 10 feet.

Let’s come back to what Zeckhauser says on this subject.

Most investors, according to Zeckhauser, whose training fits a world where states and probabilities are assumed to be known, have little idea how to deal with unknowable and treat as if risk is the same as uncertainty.  When they encounter uncertainty, they equate it with risk, and tend to steer clear. This often produces buying opportunities for thoughtful investors who shun risk but seek uncertainty on favourable terms.

Second, Zeckhauser states that historically, some types of unknowable situations – those that Taleb calls positive black swans – have been associated with very powerful investment returns and that there are systematic ways to think about such situations. And if these ways are followed, they can lead you to a path of extraordinary profitability.

One way to think of unknowable situations is to recognise the asymmetric payoffs they offer. The opportunity to multiply your money 10 or 100 times as often as you virtually lose all of it is a very attractive opportunity. So if you have a chance to multiply your money 10 or a 100 times, and that chance is offset by the chance that you can lose all of it in that particular commitment, is a good bet, provided you practice diversification, isn’t it? That’s the power of asymmetric payoffs. So, Zeckhauser’s idea of profiting from unknowable situations is akin to Taleb’s idea of getting exposure to positive black swans.

Third, there are individuals who have complementary skills – they bring something to the table you can’t bring. They get deals you can’t get. An example that comes to mind is the deal Warren Buffett got from Goldman Sachs when he bought the investment bank’s preferred stock on very favourable terms during the financial crisis of September 2008 – a US$ 5 billion investment in Goldman’s preferred stock and common stock warrants, with a 10% dividend yield on the preferred and an attractive conversion privilege on the warrants.

Essentially what Zeckhauser says is that there are people who can get amazing deals – that they have this ability to source these transactions. They have certain skills that allow them to attract such transactions to them – maybe they’ve got capital, contacts, or something in them which a typical investor does not have.  Zeckhauser advises that when the opportunity arises to make a “sidecar investment” alongside such people, you shouldn’t miss it.

For many Indians, sidecar investing can best by understood by remembering that famous scene in the movie “Sholay” in which one sees Veeru driving the mobike and Jai enjoying the free ride in a sidecar attached to the bike. That’s essentially the idea here. The investor is riding along in a sidecar pulled by a powerful motorcycle driven by a man who has complimentary skills. The more the investor is distinctively positioned to have confidence in the driver’s integrity and his motorcycle’s capabilities, says Zeckhauser, the more attractive is the investment. So how do you bring all this together?

Let me summarise.

We talked about Buffett’s idea on risk. We talked about Taleb’s ideas on uncertainty and the need to avoid negative black swans and the need to get exposure to positive black swans. We talked about Zeckhauser’s advice on uncertain and unknowable situations and how to profit from them.  Sure, as value investors, we want exposure to positive black swans. But we are not like private equity investors or venture capitalists. We are far more stingy and risk averse than those people. We want exposure to positive black swans on extremely favourable terms.

But what do we mean by “extremely favourable terms?” Well, that’s where Graham – our fourth role model comes in. Margin of Safety.