Thriving During Drawdowns
Nassim Nicholas Taleb, in his book, Antifragile, defined antifragility as:
a property of systems in which they increase in capability to thrive as a result of stressors, shocks, volatility, noise, mistakes, faults, attacks, or failures.
A common thread among outsider-type management teams, those combining excellent operating and capital allocation skills, is their ability to thrive during challenging times. When stress occurs in their product and financial markets, overall, they usually increase market share, hence becoming stronger during stress.
Similarly, since these management teams are also great investors, they add additional value through capital allocation in the form of great acquisitions or repurchases at favorable prices, which means continuing shareholders instantly benefit from an increase in per-share value.
These compounding vehicles thrive as the capital allocation toolkit carries significant optionality, maximized during volatility and stress.
Great business models + great management teams + Time = $$$
Hence: Positive optionality + Time = $$
It`s interesting to reflect on the cumulative effects of piggybacking management teams that compound good decisions yearly. Similarly, in good times, they are opportunistically preparing themselves for a different opportunity set, perhaps paying out an extraordinary dividend if alternatives are scarce, optimizing the balance sheet, and rightsizing or shredding assets at favorable prices.
If you zoom out, it is mind-boggling to study the value generated by exceptional people, appropriately incentivized, just doing it right.
Some time ago, I had an interesting discussion with a friend on frameworks for valuation. Investors with an FCF-yield approach to valuation ask themselves what their return would be if they owned the entire business. Imagine a savings account with $100 left alone, earning interest that makes it worth $110 at the end of that year. Whether you left all that $10 in there or withdrew part of it to put in your wallet, you'd still consider your return 10%.
In business valuation, the tricky part is that excess FCF not paid out in dividends is subjective, and you may never get it, or it may be wasted. That is why most people don`t count the free cash that is not distributed, and often rightly so.
The premise for not counting the cash should change when you partner with outsider management teams. Their ability to thrive during challenging times means you can look at the cash on a look-through basis. There is a higher probability that the cash will add value per share through organic initiatives or skewed capital allocation.
In the book, The Outsiders, William Thorndike wrote a chapter about Tom Murphy and Dan Burke, the power duo running Capital Cities. This duo famously combined each other’s operating (Burke) and capital allocation (Murphy) skills, in effect creating what observers characterized as a "perpetual motion machine for returns."
Investors running fully invested portfolios may not be able to buy more securities when markets are in correction mode like now, but make no mistake, the management teams are doing the job on behalf of the investor—in effect, piggybacking a perpetual motion machine for returns.