In my last post, I talked about Warren Buffett's concept of Equity Bonds. Essentially Warren Buffett observed that in the past, equities have often behaved similar to bonds with a 12%annualized coupon. He used this observation to show that unlike what was commonly thought, equities do not always perform well in high inflationary environments. In fact, most equities will perform poorly in a high inflationary environment.
That's why I believe investors shouldn't be looking for just any old equities if they want to protect themselves from inflation and focus on generating positive long term returns. I think they should be looking for asymmetric bets. But what is an asymmetric bet?
In the previous article I talked about how a great business with a strong moat is less like a bond and more like a toll road. Toll roads are essential and people usually have no alternative but to pay the toll. This makes them fantastic investments. One example of a toll road is Google. Google operates as a gateway to the internet for almost everyone. And as that gateway it extracts a toll on using the internet, which is a wonderful business to be in.
That's why Google's parent company Alphabet is one of the most valuable companies in the world. Trying to recreate Google's business from scratch would be next to impossible and they have very few realistic competitors in their core search business. Thus they have a huge moat around their business. But having a big moat around a fantastic business doesn't make Google an asymmetric bet on its own.
I've also talked previously about how a margin of safety in an investment doesn't come from the volatility of the investment or from diversifying your portfolio. I believe a margin of safety is built into the price you pay for that investment. If you purchase a stock at a price far below what you think it's worth, then you can afford to be very wrong on your valuation and you will still make money on it. The significant discount you paid is your margin of safety.
When you combine a wonderful business with a strong moat, with a significantly discounted price, that's what I call an asymmetric bet. While these situations are very rare, it is truly where you can get dramatic results in your investments.
Why do we call it an asymmetric bet? The simple reason is that the potential results are asymmetric or uneven. The famed value investor Mohnish Pabrai said it quite succinctly. An asymmetric bet is a coin flip where tails I win, heads I don't lose much. Let's spell it out in terms of coin flips. Of course investing is not nearly as simple as a coin flip but it is the same basic premise. If you were offered an unlimited number of coin flips where you would win $100 for flipping tails and you would lose $50 for flipping heads, then mathematically you should quit your job and just become a professional coin flipper.
This is a bet where the potential range of results are so much in your favour that you should be willing to risk a lot of money on it. What's most important to recognize about our coin flip offer is that the range of results are asymmetric. There's a 50-50 chance that we will lose on any one flip of the coin. But if we lose, we only lose half of what we gain if we win. This is a good deal.
An Example Using Sea Limited
Now what if we could apply this same thinking to investing in a stock. We can look at a real world example that we own called Sea Ltd (SE). The outcome of the investment is still a yes or no type of question. Can SE become the dominant e-commerce firm in South East Asia? I think there is a better than 50-50 chance that it will but let's say for the sake of the argument that the odds are 50-50.
If it does become the dominant e-commerce company, I think it could easily be valued at a price of $300-400 Billion USD. That would be about 6-8 times what we paid for it and about 3 times its current price. If it does really well then I think it could be valued close to where other dominant e-commerce platforms like Alibaba are valued which is more like $750 billion. That would be 15 times what we paid for it and 7.5 times the current market value. Clearly there is lots of upside potential here.
Why do I think SE can be the dominant e-commerce platform in South East Asia? Well they have a lot of things going for them. They have a tremendous business model which is largely melded from other e-commerce companies like Tencent and Alibaba. They are the leading player in their home markets and their growth over the past few years has been unbelievable. Their Shopee e-commerce app was the second most downloaded app in South East Asia this year. That demonstrates they have a strong ability to compete with other companies in this space. Their management team is top notch and has a proven track record of execution.
As well the pandemic has shown that the long term trends are toward more e-commerce and less brick and mortar retail. South East Asia is just in the embryonic stages of the transformation to the digital age. There are strong network effects that accrue to the largest companies in e-commerce and that is why Sea's strategy is to focus on growth and not near term profitability. In short, Sea is a wonderful business with a strong and rapidly growing moat around it.
What happens if I'm wrong? Well we bought our shares in SE mostly between $125-$150 a share. Using a pretty conservative valuation I thought the company was worth closer to $250 a share at the time. So we were getting a pretty significant discount over what I thought the company was worth. If my projections for Sea's future growth proves to be too optimistic, there's a chance that the real value of SE is less than the $250 I had originally thought. However, I would have to be drastically wrong to get a price below the $125-$150 we paid for it. In the short time that we've owned it, my projections have actually been too conservative so it's possible that I might have actually underestimated the intrinsic value of SE.
Large Potential, Uncertain Outcome
Another way to look at asymmetric bets is that sometimes companies have real options in their business which are hard to fully value today, because the outcome is just too uncertain. I'll go back to Alphabet on this. They have a self driving subsidiary called Waze that is probably the market leader in self driving technology, but nevertheless has a very uncertain future because we just don't know what that business will look like in ten or fifteen years. That being said, the potential is huge.
Let's say for the sake of argument that Alphabet's shares were trading at a price which was close to the fair value of Alphabet's business excluding its Waze subsidiary. Essentially the market is assigning little or no value to Waze. Well that means that if you were to buy Alphabet shares, you would essentially be getting a free lottery ticket on the potential of Waze. That is a great example of an asymmetric bet because the potential losses are minimal but the potential payoff is huge. Even if the likelihood of Waze paying off is very unlikely, you haven't paid anything for the option so it is still a great investment.
If you can locate these asymmetric bets, you can reduce your risk and actually increase your chances for big returns. Because these are rare however, when you find them you should be willing to invest a larger percentage of your portfolio in them in order to really maximize the opportunity. That's how you can set yourself up for outstanding long term returns.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
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