Friday, October 12, 2012

Are there elephants or rats in your portfolio?

When you are an author of two extremely successful business books, your words are bound to carry a lot of weight. And so it is with Nassim Nicholas Taleb. In fact, no one in business circles calls a highly unpredictable event exactly that. Instead, they all prefer to use the metaphor 'The Black Swan', the title of one of Taleb's most popular books. Well, Taleb would now be hoping that he gives the world yet another catchphrase, 'Antifragile', a term that is also the title of his forthcoming book.

We certainly can't predict whether Taleb will contribute a new term towards the business lexicon. But few of the ideas in the book are certainly worth making a mention. He is of the view that metabolically speaking; an elephant is vastly more efficient than a rat. However, an elephant can easily break his leg or cause significant harm to himself. A rat on the other hand can be tossed around and it will still be fine. In other words, size does lead to fragility as per him.

Now, use this comparison to describe the current problems in Europe and you will see how wonderfully things fit in. Europe was so much better off being diverse, both politically and economically. But then policymakers hit upon this terrible idea of going for a unification i.e. turning it into an elephant. And it has been all downhill from there we believe. Similarly, what hampered China, for most part of its long history, is the top down state as per Taleb. Yet another case where being an elephant led to fragility.

Interesting isn't it? Can the same rules be applied to investing as well? We certainly think so. In the investing world, elephants would be companies that are capital intensive with big balance sheets and also great deal of debt. And they may well be efficient with huge economies of scale. But are they really wealth creating? May be not to the extent required. We would rather much prefer rat like companies that require very little capital to fund their growth and use most of their cash flows to reward their shareholders. In other words, companies those are not big but rather 'antifragile' is what one should look at. So that even if there is an economic storm, they are nimble enough to take shelter somewhere and not get exposed like the big elephants. Thus, it is time you asked yourself whether your portfolio would much rather have elephants or rats?

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