Fragile state – Are investors already beginning to forget some of the lessons of the credit crisis?
In his 2012 best-seller Antifragile: Things that Gain from Disorder, Nassim Taleb divides the world into three categories. Things that suffer in stressful conditions he describes as ‘fragile’ and those that are largely unmoved or unchanged by stress are ‘resilient’. For those things that actually thrive or grow stronger as a result of stress, meanwhile, Taleb has coined the term ‘antifragile’.
There are no prizes for guessing on which of those three terms Taleb concentrates for the lion’s share of his book. Here, however, we are going to focus on one of the principal examples he uses to get across his thoughts on fragility – debt or other forms of financial leverage. In other words, when a company takes on debt, it is increasing the likelihood it will be harmed by stress, volatility or some other kind of nasty surprise.
What is more, not only does debt increase a company’s chances of something bad happening to it, the more debt a company takes on, the greater the extent of any damage will be. Since the effects of debt on the strength of a company’s balance sheet – and the risks this can pose to investors - has been a constant theme for us here on The Value Perspective, it is interesting to see Taleb cite it as a cause of corporate weakness.
One interesting angle the book takes on the subject of debt involves contrasting the fallout from the dotcom bubble bursting in 2000 with that of the credit bubble bursting in 2007/08. Clearly both were traumatic periods – in both economic and investment terms – but, because the credit bubble was funded by debt, the long-term damage has been far worse than it was after the equity-funded dotcom boom.
Of arguably greater interest still, though, is what happens once Taleb’s debt example is turned on its head – if businesses loaded with debt are fragile, are those that hold cash antifragile? To the extent that they are strengthened by being able to exploit the distress of competitors and so on then perhaps, but in the very least they should be resilient to stress. Companies are often criticised for being inefficient if they have very strong balance sheets or are reluctant to spend their cash reserves – and of course there are times when that criticism may be justified.
Indeed Taleb goes so far as to equate the idea of businesses holding cash or being principally funded by equity with ‘redundancy’ – in the sense of exceeding what might appear necessary. In other words, to use a biological example, one might argue having two kidneys seems a bit of an inefficient use of resources – until one of them fails, at which point it will be quite a relief that they come as a pair. Over years of evolution natural selection has deemed this redundancy as worth having, in the long run the extra costs have been outweighed by the benefits.
The analogy with business holds because, in the years running up to the financial crisis, people began to look at companies – often those that had historically been run with stable balance sheets, net cash positions and so forth - and berate them for being inefficient. In effect, the argument ran, this sort of strategy amounted to short-changing shareholders.
It was only in 2008/09 as the effects of the financial crisis took hold and markets underwent a period of extreme stress that the value of this balance sheet redundancy really became apparent.
However, as we have noted in articles such as Point at issue and Fever pitch, which have flagged up the re-emergence of credit instruments including convertibles bonds, covenant-light loans, collateralised loan obligations and PIK Toggle bonds, attitudes again seem to be changing and, in some quarters, balance sheet strength appears again to be becoming more an object of suspicion than respect.
The next market bubble is only ever as far away as it takes for people to forget the last one and while, again, there are times when a company may justifiably be criticised for not being sensible stewards of investors’ capital, people do seem to be in the early stages of forgetting what that stability is there for. To avoid – or at least reduce – the downside for shareholders; to try and ensure they are not left feeling fragile.
Fund Manager, Equity Value
I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.
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