A Leveraged, Capital Intensive, Competitive and Cyclical Business Is Fragile (Some Thoughts On Fragility Vs. Antifragility)

Fragile vs. antifragile. Stocks that gain from disorder, fat tails and randomness.

Fragile – handle with care:

Fragile is defined as an object easily broken or damaged. When you order something online that is fragile it most likely is labelled as “handle with care”. The reason is pretty obvious: it can’t sustain shocks, knocks, beating or being dropped to the ground.  It easily breaks apart. The opposite is antifragile:

Antifragile – do not handle with care:

Nassim Nicholas Taleb wrote a full book on the opposite of fragile: antifragile. I quote from his book:

Some things benefit from shocks; they thrive and grow when exposed to volatility, randomness, disorder, and stressors and love adventure , risk, and uncertainty. Yet, in spite of the ubiquity of the phenomenon, there is no word for the exact opposite of fragile. Let us call it antifragile. Antifragility is beyond resilience or robustness. The resilient resists shocks and stays the same; the antifragile gets better…….Antifragility has a singular property of allowing us to deal with the unknown, to do things without understanding them— and do them well……It is far easier to figure out if something is fragile than to predict the occurrence of an event that may harm it. Fragility can be measured; risk is not measurable (outside of casinos or the minds of people who call themselves “risk experts”)

Taleb stresses that antifragile is not the same as robust/resilient. A rock or diamond is robust, but they just are – they don’t gain from stress and volatility like an antifragile object.

For example, I would label tobacco, alcohol and the brothel industries as robust and resilient. Despite recessions, shocks and change of consumer preferences they have managed to withstand the test of time – like rocks. Highly likely there will always be a market for these products, either because they are addictive or serve a need for human nature (brothels). They are little exposed to disruption.

However, being antifragile can make a business evolve into something much stronger and better than simply being robust. Most likely such a company derives its antifragility from its culture, not products or services. Amazon is partly an antifragile company. As of writing the coronavirus is spreading from country to country, but I believe Amazon can benefit from the virus. Amazon doesn’t rely on visits from customers – featuring e-orders and at-home deliveries – and could actually find advantages in the current situation. Being antifragile is about having an organization that is receptive to change and can benefit from change and shocks. Google/Alphabet is another company I would put in the antifragile category. It’s a creative company that keeps on tinkering via trial and error, and hence increasing the chances of “accidentally” stumbling upon new innovations. Google provides a cultural environment that stimulates small-scale experiments which  occasionally result in a big payday. This means Google can gain on randomness!

Warren Buffett says he always keep a solid buffer in cash for unknown and unpredictable events, making Berkshire Hathaway somewhat antifragile. He wrote the following in the shareholder letter of 2005 on page 20:

Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero. That is not an equation whose effects I would like to experience personally, and I would like even less to be responsible for imposing its penalties upon others.

Why does Buffett want to have so much idle capital? One reason is that he is forced to as an insurer. However, there is another important element: he has skin in the game. Owner-managed companies typically have strong “leaders” that take a very long-term approach. Decision making is decentralized  – thus much more antifragile and receptive to change. Such businesses normally don’t have any strategic guidelines, they function much more on simple heuristics and “gut-feel” and not on scientific guidelines and “streamlined businesses”. Buffett simply does things without any grand strategic plan. He doesn’t walk into the office with a strategic mindset, but concentrates on doing the things that make the most sense at the moment. We can think of Berkshire as some kind of self-managed company where there is no top-down hierarchy. This is extremely important because most people can only feel “possession/ownership” of a project or business if they are truly responsible for it. Empirical evidence suggests this is much more important than the size of the salary.  This way you can actually create some “synthetic” skin in the game and offset lack of financial skin in the game. Another example of a decentralized and antifragile business is Canadian Constellation Software.

Fragility:

Opposite we have a business that needs to be handled with care, like for example a capital intensive, competitive and cyclical  business. Such a business is at the mercy of the economy, and additionally could potentially be bankrupted if it uses leverage to boost returns. Leverage simply magnifies the fragility of the business and it’s hard to make acceptable returns over the long term. Unfortunately, the vast majority of the public companies are within this category as explained by Hendrik Bessembinder in his study from 2017. Just a tiny number of stocks have turned out to be good long-term investments because the competitive marketplace forces most returns downward.

Airlines are very fragile:

A recession reveals those swimming naked. Currently the coronavirus has halted tourism and transport, putting a lot of strain on airlines, a very fragile business. On the 5th of March 2020 the International Air Transport Association (IATA) wrote a statement where they expect airlines to lose between 63 to 113 billion in revenue in 2020, depending on how the coronavirus spreads.

An airline needs lot of capital and leverage to operate, and additionally it’s an intense competitive industry. The chart of Norwegian Air Shuttle (an airline listed on Oslo Stock Exchange) serves as a great reminder of the problems of investing in such an industry:

Share price of Norwegian Air Shuttle.

For ten years the share price has gone nowhere. Now, in early March 2020, Norwegian Air Shuttle is trading below 20 NOK, the lowest level since 2005. Despite this, as a consumer I have benefited handsomely by being able to travel cheaply back and forth Norway and my home, usually at less than 150 EUR for return tickets (a 90 mins direct flight).

(Of course, there are exceptions in any industry: Southwest Airlines, for example.)

A capital intensive business is less likely to be a good investment:

Hassan Elmasry, then an analyst in Morgan Stanley, wrote the following in an article in The Journal of Investment Strategy Number 1 2007:

Companies that depend primarily on physical assets like real estate, factories and machinery for their competitive advantage are unlikely to earn reliably superior returns on their invested capital over the long term. Physical assets invite replication by competitors which often leads to excess capacity, price competition and erosion of returns on capital. In contrast, companies whose decisive assets are intangible, such as brands, patents, licenses, copyrights and distribution networks, can earn consistently superior returns on relatively smaller amounts of invested capital.

Elmasry measured returns against capital intensity in 2 200 public companies from both the US and Europe from 1984 to 2002. His result found an inverse correlation between returns and capital intensity:

 The evidence confirmed our own anecdotal experience as professional investors. For all time periods, the two lowest capital expenditure/sales quintiles significantly outperformed the two most capital-intensive quintiles. There appears to be a long-term constraint on a capital-intensive company’s ability to generate consistently superior growth in shareholder value. As previously discussed, we believe that this is because capital-intensive companies typically rely on tangible assets for their competitive advantage which can easily be replicated by competitors. This ease of replication encourages plentiful capacity, tough competition, weak pricing and lower returns on capital. In contrast, companies that are dominated by intangible assets can benefit from a more benign pricing environment, higher returns on capital and superior organic compounding of wealth. Investors should benefit from an investment approach focused on low capital intensity companies driven by vibrant intangible assets.

His findings are summarized in this chart:

Capital intensity and stock market return.

Credit Suisse looked at the returns for 10 000 stocks in 68 different industries by looking at returns on invested capital. The graph below shows the difference between CROIC (cash return on invested capital) and the cost of capital. There are of course companies that make good returns in an industry that on average makes a loss, and there are companies that are losing money in an industry that on average is very profitable. However, unless a company is outstanding, there are industries that perhaps should be avoided:

CROIC deducted cost of capital. Source: Credit Suisse.

But let’s return to the airline industry. In the paper by Credit Suisse they did a deep dive into the airline industry to investigate where the most profitable niches are. The industry is made up of many different companies and suppliers: airlines (Southwest, Delta, Norwegian, KLM etc), airplane manufacturers (Boing, Airbus, Fokker, Cessna), freight (FedEx, UPS), Travel agents (Expedia, Booking), logistics (Amadeus, Sabre), airports (Arlanda, Heathrow), finance (banks, leasing companies), suppliers (Pratt&Whitney, Parker-Hannifin) and ground support.

The figure below shows the profit pool for all these industries as a whole. Airlines and airports use the majority of the capital, but at the same time are the businesses with the lowest returns. Just a few businesses make all the returns – those with the least capital requirements – but the profits are too small to offset the value destruction from the airlines and airports. As a consequence, the industry as a whole destroyed an average of $17 billion of shareholder capital per year through the 2004-11 business cycle, according to the International Air Transport Association:

(The airline industry has showed better profitability since this period.)

Tobacco and alcohol are robust industries:

Credit Suisse makes every year a book called Credit Suisse’s Global Investment Returns Yearbook. In the 2015 edition the authors Dimson, Marsh og Staunton, the three professors behind Triumph of the Optimists, contributed an article where they looked at the best industries in the US and UK between 1900 and 2015. The worst industry was shipping with only 6.4% return, and best was tobacco with 14.6% return (the US stock market had 9.6% annual return in this period). The return for tobacco stocks is impressive, especially considering that the number of smokers has dropped from 50% in 1970 to less than 15% today. Shipping is a capital intensive business, while tobacco is the opposite. Furthermore, it’s very difficult to obtain any competitive advantages in shipping, while regulation limits competition in tobacco.

In the UK another “sin” industry has performed the best: alcohol.

Conclusion:

The stock market is full of volatility and randomness. Companies come and go, and most companies simply vanish – they get merged, acquired, go into oblivion or go bankrupt. Opposite, a business that is antifragile can prosper in unpredictable and random markets. Unfortunately, these companies are rare, but I hope this article has given you some clues what to look for.

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