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Thriving During Drawdowns
Nassim Nicholas Taleb defines antifragility in his book Antifragile 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 denominator among outsider-type management teams that have superior operational and capital capabilities is their ability to thrive in difficult times. When stress occurs in their product and financial markets, they typically increase their market share, making them stronger in times of stress.
Because these management teams are also excellent investors, they create additional value through capital allocation in the form of great acquisitions or buybacks at favorable prices, which means that continuing shareholders immediately benefit from an increase in value per share.
These compounding vehicles thrive because the capital allocation toolkit has significant optionality that is maximized in the face of volatility and stress.
Great business models + great management teams + Time = $$$
Hence: Positive optionality + Time = $$
It is interesting to think about the cumulative impact of management teams making good decisions year after year. Similarly, when times are good, they opportunistically prepare for other opportunities, perhaps paying an extraordinary dividend when there is a lack of alternatives and optimizing the balance sheet.
When you zoom in, it's amazing to see the value that exceptional people with appropriate incentives create by simply doing everything 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. Regardless of whether you leave the entire $10 there or withdraw a portion of it to put in your wallet, you would still consider your return to be 10%.
The difficulty with business valuation is that excess FCF that is not paid out in dividends is subjective and you may never get it or it may be wasted. For this reason, most people do not count undistributed free cash, and often rightly so.
The premise for not counting the cash should change when you partner with outsider management teams. Their ability to succeed in difficult times means you can look at cash on a look-through basis. There is a higher likelihood that 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.