How to Barricade Against Black Swans

Jason Pohl

ECP Asset Management

Wealth compounds over the long term. When investing, we do so under considerable uncertainty, and sound risk management strategies are necessary to ensure we generate above-average returns. However, the longer the investment horizon, the greater the probability of experiencing unforeseen events and the more pronounced the exposure to idiosyncratic risks. Identifying resilient, high-quality franchises is an investor’s optimal risk management tool to manage future uncertainties. Here, we illustrate how antifragile companies protect portfolios from the unknown.

The past few decades have been a golden era for most traditional assets as interest rates steadily declined and economies expanded, relishing globalisation and technological innovation. Investors tend to extrapolate history into the future, assuming regularity of fundamental drivers; however, in times of stress, these become less reliable.

Equity investors seek to identify businesses that will increase in value over time. The goal of any investor is to forecast future expected returns based on the best estimate of what we expect the future will be.

When forecasting, rare (black swan) events present a material risk for investors; we know with certainty that rare events will occur. History is littered with systemic stressors that appear more regularly than they should, statistically; the GFC, COVID-19, and the recent war in Ukraine are examples of these events that have affected businesses worldwide.

However, many invest as if black swans do not exist. Solely focusing on the opportunity ahead while failing to account for this level of uncertainty means investors fail to account for ambiguous, unforeseen risks.

The ability of anyone to fully account for all future outcomes is impossible. Moreover, investors that attempt to predict black swans may make them more vulnerable to the ones they failed to predict.

Black swan events are low in predictability and high in impact. By this, we are not talking about share price performance but rather the performance of the underlying businesses. In anticipation of these events, preventative measures are necessary to protect portfolios from unpredictable risks.

So how do we prepare for black swan events if we do not know what they are or when they will strike?

Proceed with Caution

The intrinsic uncertainty of the world, the numerous stakeholders in place and the systemic nature of rare events make it incredibly unlikely that companies that are not resilient can prevent all these risks over the long term.

Investors are loss-averse, not risk-averse. When investing over long-term horizons, risk management strategies need to account for the unforeseen risks that may lead to capital loss.

Identifying asset resiliency is the optimal preventative measure to mitigate uncertainty and change. By aligning with sustainable business economics, portfolios will possess the idiosyncratic essentials to compound economic returns.

When investing, we are (generally) exposed to three primary issues:

  1. The risk that performance falls below a target threshold;
  2. The risk related to the reliability of an investment’s underlying performance; and
  3. Failure to manage uncertain risks that lead to fluctuation according to the non-predictable future state of the world.

Investors tend to manage risk and uncertainty through a probability-based lens, using variance as a proxy for risk. Here, investors assume the normality of returns distribution when the probability of black swan events occurring is higher than suggested.

Nissim Taleb, author of ‘Antifragile: Things That Gain From Disorder’ introduced the concept of antifragility. Here, randomness, uncertainty and chaos are welcomed, as when these systems are under stress, they are resilient and then improve — they gain from this disorder.

Unlike fragile items, which break when stressed, the antifragile benefits from volatility and shock. Antifragility is beyond resilience — the resilient manages, adapts, and resists shocks, whereas the antifragile gets better. Antifragility is the antithesis of fragility.

There’s a saying in finance that during times of crisis, the return correlations of all risky assets go to 1. Asset prices move similarly — down and fast. Resilient investments recover much faster, while antifragile assets will improve.

Much like the human body, we need stressors to ensure that we are in good shape and that we improve and grow. Resilience is the blueprint for living in a black swan world. Antifragility is the key to sustained, above-average investment performance.

It is difficult to predict when something will cause something fragile to break. However, incorporating resilience into risk management frameworks means using these heuristics to guide non-predictive decision-making under uncertainty. Resilience is the antidote to genuine uncertainty.

Let’s Illuminate

There is no risk in steady-state environments, yet it is not so simple when we find ourselves in situations of change. For investors, change increases risk because we do not know its effects, leaving open the possibility of unexpected consequences.

As investors, we are essentially business owners. Finding resilient companies means investing in those that can grow their economic footprint while strengthening their competitive advantage despite rare, unforeseen events.

Since a company’s free cash flows (FCF) are the key determinant for future valuations, it is sensible to identify which businesses can continue to execute their business strategy without being negatively impacted by black swan events — the highest quality franchises.

Businesses that generate predictable, above-average returns deliver superior value creation over time. These high-quality franchises have strong FCFs, a sustainable competitive advantage, high returns on invested capital, and a solid financial position. Importantly, they hold a Dynamic Capability which provides the ability to manage and adapt to change.

The Antifragile Academic

IDP Education (ASX: IEL) is a major player in the international education market. The business operates a global student placement platform and distributes IELTS, the gold standard high-stakes English language test for students and immigrants worldwide.

The education sector was one of the hardest hit by the pandemic as it relies on the movement of students and immigrants across borders. As the world shut down, IDP had to rapidly transition from in-person events and counselling to a virtual platform and shift the IELTS tests online.

IDPs size, scale and existing digital expertise allowed it to execute its business strategy seamlessly. At the same time, its dynamic capabilities proved to be the key attribute in further extending its competitive advantage.

Indicators of their adaptive capacity during the pandemic:

  • IDP had almost no debt heading into the pandemic. At the time of global shutdowns, IDP raised ~$190m in equity (<10% of issued capital), deferred its dividend, increased its debt facilities and cut operating costs, mitigating any balance sheet risk for the foreseeable future.
  • The company’s multi-destination strategy meant that it serviced students travelling to predominantly Australia, UK and Canada. While Australia suffered the largest drop in student numbers, the UK remained relatively open, making IDP far more resilient to the pandemic than its peers who serviced single destinations.
  • Rare events can catalyse competitive behaviour, favouring the more resilient. IDP’s acquisition of the British Council’s (BC) Indian IELTS business, which has long been recognised to hold significant synergies, saw the IDP leverage the capital raised to drive strong EPS accretion. Arguably, this might never have occurred without Covid-19 (the pandemic placed financial strain on BC, driving the need for capital).

IDP’s digital strategy has been a strengthening competitive advantage, with the company continuously taking market share. The pandemic was a black swan event impacting the business; however, it proved beneficial given the antifragility of IDP — accelerating market share gains leading to an increasingly stronger business had the black swan event never occurred.

Investors could never have predicted these events or incorporated them into an investment thesis. However, the company’s resilience could have been identified by acknowledging 1) a highly experienced and competent management team, 2) a strong balance sheet providing it with optionality, and 3) a digital strategy that was not reliant on any one revenue stream.

The Resilient Rollout

Domino’s Pizza Enterprises (ASX: DMP) owns and operates the exclusive master franchise in several global territories. Through time, the company has been exposed to several externalities, including underpayment of wage accusations, the pandemic, and the recent inflationary environment.

Domino’s resilience has been pervasive through time. The company is highly entrepreneurial, focusing on innovation and knowledge retention while demonstrating a clear ability to manage and adapt to change. All of which continually renew and extend their competitive advantage.

Domino’s continually redeployed and reconfigured its resources to meet evolving customer demands. Whether innovative menu offerings, in-store efficiencies, or optimising their route to customers, Domino’s demonstrate an adaptive capacity that ensures they constantly improve their operations to deliver hotter, fresher pizza while rolling out new stores.

Indicators of their adaptive capacity during the pandemic:

  • The pandemic drove heightened risks to the business, given their exposure to carry out sales — half of their business was entirely wiped out overnight. In turn, the company pivoted toward their delivery service, leveraging cheap national TV advertising while providing new routes to its customers (car park delivery).
  • Inflationary pressures continue to impact the business, with franchisees suffering the effects of food and labour inflation globally. Here, Domino’s are pulling on several levers to combat these pressures, such as using their coupon and loyalty programs to drive consumer behaviour toward higher margin products.
  • The European energy crisis is presenting another large impact on their operations. In Germany, they reduced ‘active territories’ by ~10% (with a further 8% expected) to help drive efficiencies and support franchisee margins due to the lower cost per delivery.

The unfolding chaos of the industry will see poorer restaurant operators go out of business in the coming years. While we cannot provide evidence of their antifragility (yet), the benefits of the strength and resilience of their business model will come to fruition in the medium-long term — its competitive position is only strengthening.

In the face of externalities, Domino’s has demonstrated an ability to reconfigure its resource base to mitigate the threat — its resilience stems from systems and processes that create and retain resources driving future competitiveness. Domino’s relentless focus on franchisees, nurturing human capital, and continued operational efficiencies will ensure their store-rollout objectives will continue over the long term.

Resilience: The Antidote to Black Swans

The future is uncertain. Rare events are unavoidable. The longer our investment horizon, the greater the uncertainty and the higher the probability of black swan events. Taking a precautionary approach reduces the likelihood and severity of these events.

The pandemic, devastating weather events, and the invasion of Ukraine are examples of macro-environmental shocks impacting companies worldwide. Portfolios that comprise resilient, sustainable investments provide a degree of comfort amidst market uncertainty and maximise the likelihood of resilient performance over the long term.

Investors that fail to mitigate uncertain risks will almost certainly lead to underperformance, however, accepting uncertainty and applying resilience-based risk management principles can mitigate these risks in situations of major systemic disruptions.

When selecting investments, companies that are resilient in the face of these challenges are vital, while finding antifragile companies is the key to long-term investing. Resilient businesses will manage and adapt when the uncertain materialises.

The market’s tendency to overreact to short-term events presents a unique investment opportunity. The best antidote to the (current) lower-growth, uncertain world is to invest in high-quality resilient companies. Seek out the antifragile and concentrate your portfolio on these, they are the best protection against unknown risks.


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The article has been prepared by ECP Asset Management Pty Ltd (ECP). ECP is a funds management firm based in Sydney, Australia. For further information, visit www.ecpam.com. This material has been prepared for informational purposes only, and is not intended to provide and should not be relied on for financial advice. ECP and the analyst own shares in Domino’s Pizza Enterprises Ltd and IDP Education Ltd. ABN 26 158 827 582, AFSL 421704, CAR 44198.

2 stocks mentioned

Jason Pohl
Partner
ECP Asset Management

Jason is part of the ECP investment team that manage a concentrated portfolio of companies in the growth phase of their life-cycle, able to expand their economic footprint through time. Jason is a Partner at ECP, and is the Head ESG Officer.

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