“At Oaktree, we believe that because there’s so much we can’t know about the future, we should invest only where our analysis tells us the worst case is tolerable.”
— Howard Marks, memo to clients (pdf) dated March 11, 2003.
Many observers have noted that the events that have taken place in Japan over the past week represent a classic “black swan” event, a concept popularized by Nassim Nicholas Taleb in his book The Black Swan. Certainly the magnitude of the 9.0 earthquake itself was a low probability event but it was not an inconceivable event. However, the quake was only the start of a series of chain reactions beginning with the massive tsunami which caused shocking damage to Japan’s coastline and physical infrastructure with disastrous consequences for the Fukushima Daiichi nuclear power plant.
The reactors at the Fukushima Daiichi plant were constructed in the early 1970s in a manner designed to withstand a 6.5 magnitude earthquake, a tremor far smaller than the 9.0 quake based on the logarithmic nature of the Richter scale. However, the current nuclear disaster was not caused by a direct failure of the containment system but by a chain reaction caused by failure of cooling system pumps to keep the nuclear fuel rods at a safe temperature. These pumps were disabled by the tsunami caused by the earthquake. Workers at the plants have been trying various approaches to cool the reactors but a series of explosions have caused dangerous levels of radiation to escape in the local area of the plant and measurable radiation to increase in distant areas (for a summary of the latest developments as of this morning, refer to today’s article in the Wall Street Journal).
Worst Case Scenarios
The Japanese stock market has reacted to the disaster with a rapid decline over the past week and stock markets throughout the world have declined as well. The combination of the sell off and relatively low valuations in the Japanese markets even prior to the disaster have led some analysts to focus on opportunities in Japanese equities as well as potential opportunities in distant countries where valuations have declined.
In terms of Japanese equities, in addition to analyzing individual companies, it is necessary to also come to grips with what the “worst case” nuclear scenario might look like and the probability of such a scenario taking place. While the situation is uncertain, there are some facts that we do know based on numerous reports and interviews that have been published (click here for one recent report quoting experts):
Chernobyl Scale Disaster Comparisons Lack Merit. The worst nuclear accident in history was the 1986 meltdown of the reactor at Chernobyl. The reactor design in Chernobyl lacked many of the safety mechanisms featured in the Japanese reactors including the presence of primary and secondary containment systems and the fact that the Japanese reactors are cooled by water. The Chernobyl reactor temperature was regulated by graphite which burned and dispersed into the atmosphere unhindered by containment vessels. This scenario is not possible with the Japanese reactor design.
Radiation Exposure Limited For Now. Elevated levels of radiation have been measured in Tokyo which is 150 miles from the reactors, although officials claim that the radiation levels are not harmful to human health. The main risk from radiation is presently impacting the plant workers and individuals within the area of the evacuation orders. The plant itself is located in Fukushima Prefecture which has a much lower population density than areas surrounding Tokyo.
Worst Case Scenarios are Sketchy. While the worst case scenario in Japan is not as negative as the situation at Chernobyl, a full scale meltdown of several of the reactors cannot be ruled out at this point given the continued struggles officials are having with the cooling systems and the localized spikes in radiation that have limited the military’s attempts to take drastic measures such as dropping water on the reactors from helicopters. The Japanese government has not clearly publicized the worst case scenario perhaps due to concerns over creating panic among the population. We have been unable to find clear data on the effects of (1) a full meltdown in one or more reactors coupled with (2) a breach of one or more of the primary containment systems and (3) wind conditions that could carry the resulting fallout toward more populated areas such as Tokyo.
Unlikely is not Impossible
Let us recall that the current disaster was not caused by a single improbable event but by a series of three improbable events. First, a 9.0 magnitude earthquake struck off the coast of Japan which itself was a very low probability event. Second, a massive tsunami developed due to the quake and devastated much of northeast Japan’s coastline including the area of the nuclear plants. Third, the cooling systems at the plant broke down leading to the chain reaction that continues to resist containment at this time.
We view the worst case scenario in Japan to involve: (1) a full meltdown of one or more reactors combined with (2) a breach of one or more of the primary containment systems resulting in atmospheric dispersion of radiation and (3) adverse winds blowing the radiation toward Tokyo or other populated areas.
The probability of each of these events may vary and hopefully none come to pass. However, without being able to fully quantify the impact of an adverse result in each of these areas on human health and potential economic disruptions, it is very difficult to quantify the level of risk involved in Japan at the present time.
It is possible that some investors may have access to “worst case” scenario information not readily available in the media and have been able to either conclude that the worst case scenario is relatively benign from a health and/or economic perspective or that the low probability of a very harmful worst case scenario still results in an adequate prospect of attractive investment returns in light of the risk. Such investors may decide to proceed based on the evaluation of the risk/return scenario.
Investing is all about accepting a level of risk in exchange for the prospect of investment returns. We applaud analysts who have been able to arrive at an assessment of risk that permits intelligent investment in Japanese securities at the present time. However, for those who lack such insights, “buying the dips” without an adequate understanding of the true worst case risks involved could lead to poor results. Even if such buying ends up being profitable because the worst case scenario did not come to pass, this does not mean that making such commitments represents an intelligent investment unless all potential scenarios were truly evaluated at the outset.