The Digest #14

Published on March 25, 2020

In Today’s Issue:

  • Another Wild Week
  • Coronavirus Is Not a Black Swan
  • Small Businesses in Crisis
  • The Sober Math of a Pandemic

To read last week’s newsletter, which contained an essay regarding coronavirus and the road ahead, please click here.

Another Wild Week

We are in the midst of another wild week of activity in financial markets. After falling 2.9% on Monday amid concerns that the federal stimulus bill did not pass over the weekend, the S&P 500 rose 9.4% on Tuesday on hopes that the legislation will soon pass. At least that is the narrative that most headlines presented to explain these massive moves in stock prices. However, the truth is that journalists and analysts are mostly speculating regarding the sentiments and motives of countless buyers and sellers. Retroactively constructing narratives to fit the past is a hazardous practice especially in times like this. 

There are many places to read market summaries and speculation regarding the motives behind market moves and there would be little value in adding to the cacophony of speculation here. The truth is that the markets will continue to wildly gyrate for the foreseeable future because there is tremendous uncertainty regarding the range of possible outcomes of the coronavirus crisis. 

As of late Tuesday afternoon, negotiators are supposedly nearing an accord on a massive $2 trillion stimulus package that may be finalized by the time you are reading this email. Although there is much debate regarding the contents of the stimulus, there seem to be few people who deny the need for one at a time when government mandated shelter-in-place orders have shuttered countless businesses and interrupted income for millions of Americans. 

Over the weekend, I published Berkshire Hathaway and the Coronavirus Crash which was an attempt to examine the implications of the crisis on Berkshire’s future business prospects. The article has been viewed over 4,400 times over the past forty-eight hours and I hope it is helpful to Berkshire shareholders thinking about how the crisis impacts the company. 

Berkshire Hathaway seems to be positioned well for the eventual recovery, but the contours of the recession to come and the timing of the eventual recovery remains very much in question. After weeks of debate regarding whether the crisis will lead to a recession at all, dire estimates are starting to come out regarding the obvious fact that we are in a deep recession.  For example, Goldman Sachs believes that the economy will decline by 6% in the first quarter followed by a 24% decline in the second quarter. Goldman expects a second half rebound, but in reality the magnitude and timing are totally uncertain.

The best we can hope for at this point is that we can contain the coronavirus sometime in the second quarter which will allow economic activity to get back to normal in the second half of the year, and that pent-up demand sparks a massive rebound in activity. If we get the hoped-for “V shaped” recovery, the economic damage will be limited. However, it is not inconceivable that consumer confidence is so shaken that the recovery is much more tepid. Shaken by the trauma of the crisis and the limited margin of safety in the personal and business finances of so many, a period of retrenchment may lie ahead. Although conservatism in finances at the micro level might be a virtue, if adopted economy-wide, the recovery will be slow. Only time will tell.

Coronavirus Is Not a Black Swan

Nassim Nicholas Taleb had the following to say about the risk of pandemics in The Black Swan which was published in 2007:

“As we travel more on this planet, epidemics will be more acute — we will have a germ population dominated by a few numbers, and the successful killer will spread vastly more effectively…. Once again, I am not saying that we need to stop globalization and prevent travel. We just need to be aware of the side effects, the tradeoffs — and few people are. I see the risks of a very strange acute virus spreading throughout the planet.”  

The Black Swan, p. 317

Taleb is not a prophet but he is someone who has made a career thinking about risk. In his formulation of the concept of black swans, such an event must be unpredictable and have massive consequences. Indeed, coronavirus is having massive consequences but was it unpredictable? We could not have predicted the timing or the specific characteristics of the virus but, as Taleb’s own writing makes clear, it was possible to see that the dramatic increase in the speed of travel over the past century has made the risk of a “strange acute virus” much greater than ever before.

What does Taleb himself say about whether coronavirus is a “black swan”?  He has said that it is not, both on Twitter and in a brief BBC radio interview.

But is it even important whether we label the pandemic as a black swan or not? It is, in the sense that characterizing something as a black swan is often done to absolve people of accepting responsibility for not being prepared. Governments have a duty to be prepared for foreseeable events. So do managers of large corporations who should operate with enough financial conservatism to survive unpredictable events without necessarily knowing the specifics of the disruption in advance.

Investors need to watch out for companies that attempt to absolve themselves of responsibility for poor risk management by citing “black swans”. CEOs are human beings and everyone makes mistakes, but executive compensation plans should not be retroactively adjusted to shield managers from sharing in the pain of this situation. Otherwise, we have a “heads I win, tails you lose” compensation structure that unfairly puts the burden of the pandemic entirely on the shoulders of owners.

Small Businesses In Crisis

Black swan or not, the crisis is having a major impact on small businesses throughout the country. I am sure that I am not alone when I see dozens of local businesses first reducing hours and then shutting down entirely. The pattern for many restaurants in my neighborhood is that they operated normally as long as possible, then went to limited hours for take-out and delivery once the local government prohibited dine-in service, and now many are shutting down entirely. Many will not come back if the crisis lasts very long. 

Every business is different in terms of fixed and variable costs. Most retail businesses have substantial fixed costs, most obviously rent for the storefront itself, but many also have tried to pay at least some of their employees when partially or fully shut down. That’s great to see but can have dire cash flow consequences. The typical small or mid-sized business has limited cash reserves and business finances are often commingled with personal finances for owner-operators. 

Patrick O’Shaughnessy’s recent interview with Brent Beshore is worth listening to for those interested in the challenges facing smaller businesses in the current crisis. The segments related to the length of time a typical small business can survive a shutdown and the challenges involved in eventually re-starting operations were particularly insightful. Additionally, Beshore presents a balanced view of how capital allocators can step in to assist companies that are fundamentally sound but might be having liquidity issues. In a crisis environment, capital allocators naturally require a significant margin of safety but when one also wants to build a long-lasting business relationship with an owner-operator, it is important to use some restraint when it comes to negotiating the terms of an investment.

The Sober Math of a Pandemic

It is difficult for most people to think in terms of exponential functions. There is something about the human brain that likes to think in linear terms and extrapolate figures in an additive manner. The explosive power of compounding is often not recognized until a trend has become impossible to ignore. Indeed, the power of exponential functions is one of the most critical mental models for investors, but also for everyone else. 

I wish more people had read Jason Warner’s article, The Sober Math Everyone Must Understand about the Pandemic, when it was originally published on March 12. This article, which apparently went viral with millions of views, explains how a linear way of thinking early in the crisis fooled people into thinking that the eventual spread would not be a big deal. Thinking in terms of exponential math is simply non-intuitive for the vast majority of people. This is why many people do not save or go into credit card debt. The consequences of not knowing this mental model is magnified when it comes to a pandemic.

This “sober math” is important not only for policymakers but for the population at large. It is terribly difficult to convince the general public to accept restrictions on activity while the number of cases remain relatively low. In fact, if you get the public to accept restrictions when the case numbers are low and you avoid disaster, as a policymaker you will probably be criticized for over-reacting!

Obtaining public support in a democracy is critical. The shelter-in-place rules currently in effect will not work if there is not broad public support for them. The United States is not a police state and enforcement cannot (and should not) approach the authoritarian levels seen in places like China. But public buy-in depends on understanding the reason for these policies.

Hopefully, this crisis will convince the education establishment to not allow anyone to graduate from high school who has not mastered exponential functions and can apply this basic math to common areas of day-to-day life, especially compound interest. Financial illiteracy is not among our top concerns at the moment, but the financially literate are more likely to immediately understand the sober math of pandemics.

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Copyright and Disclosures

Nothing in this newsletter constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC. 

The Digest #14