Shit will happen
Even in good businesses. That's why sensible investing rests on humility and safety.
Military acronym for Situation Normal, All F#*ked Up;
A situation marked by errors or confusion.
The trouble with my ‘own good businesses’ spiel is that I inadvertently convey a sense that all izz well so long as I stick to this process. I downplay how omnipresent screws-ups are, even in good businesses. Correcting this impression is both necessary and overdue. Snafus are the default state of the world, even at the good business end. This eternal truth has to underpin any sensible investment process.
I have generally stayed true to the process I write about: no ruinous risks, trustworthy people, good industry, well-placed company, sensible price. Yet, most of the time, something big goes awry. It’s serious enough for me to (temporarily) doubt my thesis. Oftentimes, I feel like a horse’s ass. What sorts of snafus am I alluding to? Industry turned out worse than expected. ‘Cyclical’ demand weakness lasted for a decade instead of years. Business lost a key customer, collaborator or manager. Pursued high-risk M&A or poor capital allocation. I underestimated severity of ‘transient’ problems that led to buying opportunity. Execution missteps, due to distractions or otherwise. Sustained erosion in competitive position. Discomforting balance sheet stretch. How often did I encounter one of these? Nine times out of ten. Picture playing out as envisaged was the exception rather than the rule. This wasn’t entirely due to my stupidity, although that contributed. It’s innate to buggy humans and messy world. Even with a robust construct, business trajectory isn’t linear.
Why confess now? To clarify an important nuance. A sensible process doesn’t eliminate snafus. Sure, it reduces the odds through basic safeguards such as avoiding history-sheeters, but that’s low hanging fruit. So long as there are buggy humans, there will be screw-ups. The point of a sensible process is to limit the adverse consequences of inevitable snafus and enable reasonable outcomes despite them. For this, humility and caution have to be its core tenets.
Herein lies the real reason for my incessant harping about margin of safety. And why it’s crucial to adopt it as an overarching mindset rather than a final valuation check. Every level of safety helps bolster resilience to snafus. Biggest safety lever is having an aligned, focused, trustworthy promoter. While there may be temporary differences in perspective, anything bad for me is bad for him. And unlike me, he can do something about it. Such promoters are more likely to be objective in postmortem and firm in remedial action. They may even use tough times as an opportunity to spring clean their way out of laggard divisions or legacy mistakes. Strong balance sheet provides a longer runway to recover from a setback. So does a forgiving industry where very few can take advantage of a misstep. Best-run player is more likely to exploit adjacencies in the face of a prolonged downturn in the core. Last-man standing in a tough industry will even emerge stronger after tough times, as less resilient companies wither away. Such companies also possess the depth to fill the void from lost people or business. At the least, multiple levels of safety ensure that screw-ups don’t become blow-ups. At best, they instill anti-fragility.
The valuation safety-margin is important too. Resilient doesn’t imply costless. There’s certainly a setback, especially factoring in opportunity costs. A few years are lost. Compounding is interrupted. Recovery may not be to 100% of pre-snafu strength. Valuation may correct as buggy humans realize that their Gods bleed. A more general implication of omnipresent snafus is that compounding is never steady, even in the best of companies. Real world follows a two-steps-forward, one-step-back rhythm rather than the cocksure monotony of our click-and-drag world. Valuation discipline is simply an acknowledgment of this truth. It’s function is to enable a passable return even when shit invariably happens.
I started with a stark 90% snafu rate, partly to get your attention. However, business and return outcomes aren’t nearly as bad in my ‘own good businesses at reasonable prices’ spiel. They might even be skewed in the other direction, thanks to aforementioned safety levers. In most cases, safe and good businesses recover from snafus, given enough time (years, not quarters). Valuation discipline limits capital losses or unsatisfactory returns. The magic of margin of safety leads to this divergence between snafu rate and fatality rate.
Recognizing snafus as the default state of the world also helps post investing. I remain paranoid but patient. Paranoid, as screw-ups are only a question of when and not if. My antennas are up for the slightest hint of distraction, diversification, M&A, or more mundane signals around share loss or balance sheet stretch. While I have no ability to fix any business problem, I can diagnose it as well as an outsider can. And ensure that management isn’t deluding themselves about its presence or severity. So long as I’ve got my safety levers right, plan A is to simply give it time, while staying updated on the problem and its redressal. While there’s no guarantee, odds favour waiting (watchfully & uncomfortably) rather than exiting. If it becomes irredeemably bad, then plan B.
Buggy humans are prone to overconfidence. In investing, this can turn into outright arrogance, especially after a generous dose of dumb luck or easy money. Compounding being the most powerful force in the world becomes a dangerous siren song. In a place where most lag the index, such arrogance is both unjustified and dangerous. We’re also not wired to wait idly, especially as less discerning idiots make out like bandits. Whether out of frustration, hubris or envy, we’re perennially tempted to relax one safety margin or another. At extremes, this manifests itself as either (a) pay any price for ‘great’ business or (b) buy any crap so long it’s cheap, with a whole spectrum in between.
My method to avoid this slippery slope is to constantly remind myself of this 90% snafu rate, even in the best of businesses. It’s not ‘shit can happen’. It’s ‘shit will happen’ This helps me stay clear of large numbers thrown out mechanically by XL compounding. On the contrary, I invest knowing that compounding is far from steady or assured. There’s a decent chance I’ll look stupid and delusional. This holds me back from crossing red lines on safety, goodness or valuation, especially in weak moments where I’m prone to snafus myself.