Imagining Improbable & Friedman or Goldman

In a recent National Geographic piece, Laurence Gonzales, author of the excellent “Deep Survival” wrote a piece describing the unfortunate and perhaps preventable death of an adventurer to an avalanche. Gonzales invokes a quote from Christopher Burney--a British commando captured and imprisoned at Buchenwald, the concentration camp, during WWII. Burney said: "Death is a word which presents no real target to the minds eye." Gonzales, turning our attention back to his fallen adventurer protagonist, says: “Death was a failure of imagination.”

And so it is in markets. Forget formulas, imagining the improbable. This is the absolute best form of risk management. Imagine what could go wrong and more importantly what the consequence of something going wrong is. Losing money: unpleasant but bearable depending on the magnitude. Losing your life: remember anything times zero is zero. I’ve written in the past, that the more we know (ie. the wider the area of our searchlight) the less we know (ie. the greater circumference of the dark unknown). It’s why complacency leaves to catastrophe. How comfort or ignorance of risk leads to failures. We compound the unknowns. It’s what lurks on the edges of that searchlight that might provide the greatest opportunity or the greatest risk. And it’s why so many things in life are so damn exciting.

Of course: today's disasters are tomorrow’s safeguards. Insurance, material safety data sheets (in chemistry labs), laws all came respectively from explosions, corrosions and corruptions.

So, what disasters loom? Start with what everyone takes as granted? What would take people by surprise? Will Gold, oil and every other commodity you can name continue their ascent? Is it more likely the Chindia demand narrative and gospel keeps people in the pews? Or do already high expectations and fewer incremental buyers on the margin mean vulnerability for surprise? Why is their virtually no media coverage of the rise in Oil as primarily a function of dollar decline and speculation? Over time, commodities approach their marginal cost of extraction. And being commodities: they’re undifferentiated and compete on price. When have VCs ever in history made money chasing ways to produce a commodity? Why do people keep insisting that solar is attractive when Oil is at $100 when we barely produce any electricity from oil? 50 years ago, sure—but oil is a declining piece of our energy pie as more and more things become electrified. What effect would an “unexpected” decline in commodity prices have on emerging markets? I’ll return to this in a moment.

Meanwhile, James Montier of Societe General (not the rogue trader) recently pointed out a few must note statistics: Some of the prediction markets like Intrade put current odds of a recession at 65%. The S&P 500 P/Es are about where they were in 1929—not cheap. US earnings haven't historically grown during a full cycle (ie. peak-to-peak or trough-to-trough) more than 6%. And as Jeremy Grantham will tell you: profit margins are the most mean-reverting sequence in all finance, or else capitalism is broken. Large caps are more liquid than small caps yet are trading at a discount to them, which means small caps basically have a liquidity premium that is negative.

The same thing holds for emerging markets. Given their higher risk and uncertainty they’ve historically traded at discount. Not so today. And as I note above: gold, oil, copper and the commodity cabals are all currently through the roof. But the roof of housing has caved in. Commercial real estate appears to be next. Demand slows. Prices fall. And if prices fall, then those emerging markets so heavily dependent on the outrageous prices for commodities (benefiting the owners of capital, yet crippling the population) will begin losing money. As they say of emerging markets: it’s where emergencies emerge. All the same people claiming “decoupling” were claiming “globalization” before. You can’t have both. You must choose: Friedman or Goldman (ie. Thomas Friedman (the world is flat) or Goldman Sachs, which started the “decoupling” meme).

Countless friends at hedge funds lamented to me how horrible January was. Cash levels at mutual funds are at all time lows and so are average holding periods at around nine months. Meanwhile, empirical studies have shown two very interesting things about short holding periods. The first: the shorter you hold the worse the returns. The second: the shorter you hold--the more any gains are likely to result from randomness, noise and luck rather then skill. Those focused on monthly or quarterly performance and a short investment duration--that matches the liquidity demands of investor redemption durations --have to do something. Idle hands are the devils workshop. A devil of our own design, as Rick Bookstaber might say. Or as Blaise Pascal might say, all human evil comes from a single cause, man's inability to sit still in a room. Sometimes inaction is the best action.

Meanwhile all the people chasing growth are chasing high-tech flyers and solar stocks at any price with little attention to value. Remember price is what you pay and value is what you get. The implied expectations reflected by current prices calls for 40%+ annual growth for more than 10 years--no company grows that much for that long. That’s doubling less than every 2 years. The other growth area as I noted before are commodity and mining players who are and have always been cylicals. That means cycles! Like Newton: what goes up must (eventually) come down. These are high expectations and high expectations mean big reactions to disappointments.

Consider this: go see “There Will Be Blood”. Believe me when I say it’s the absolute best movie you can and will ever see in your life--the cinematography, the script, the acting, the music, the wardrobe. Now believe me when I say you shouldn’t believe what I just said. I don't really believe it’s the best movie ever, though it’s a fair way to enjoy two hours of your roughly 683, 280 hours of life—or 9,000 thumps of your roughly allocated 2.8 billion heartbeats. My point is this: high expectations can make things worse when actually experienced. And never was this truer than in markets.

A few years ago, I wrote this:

“Friends married this past weekend outside of Rome offering a chance to recharge amongst the juxtapositions of antiquity and modernity. A crypt affixed to an old church held the meticulous and macabre skeletal remains of capuchin monks. Their eerie truth etched and echoed “Quello che voi siete no eravamo quello che noi siamo voi sarete" which translates to: What you are now, we once were; what we are now, you will be.

I often write about (and less often adhere to) emotion and reason, specifically to be an abolitionist given Humes’ decree that reason is a slave to emotion. Roman ruler Marcus Aurelius noted nearly 1,000 years ago, “If you are distressed by anything external, the pain is not due to the thing itself, but to your estimate of it; and this you have the power to revoke at any moment”. Or as Aesop said, “It is with our passions, as it is with fire and water, they are good servants but bad masters.” Emotions respond first. So, having a strong backup system of calculated rational thought is essential.

My flight home reminded me of the importance of backup systems. If you’re flying on an airplane with a cockpit control system that’s got a 99% success rate, which is backed up by another system that has a 90% success rate, it will fail only 0.1% of the time. But if you’re on a flight where the plane requires both systems, its going to fall 11% of the time. The latter being 1,000 times more dangerous than the former.

The same thing goes for companies. As an investor we build a portfolio. The diversification is one backup system. The individual company having management that can adapt to a changing environment (or a faltering technology or product) is yet another backup system. Remember Darwin didn’t point to the survival of the fittest but to the survival of the most adaptable. A platform company with a multitude of real options (and real optionality) is yet another. Read: In case of emergency, break course fast. Price is yet another backup system. The lower it is relative to assessed intrinsic value, the higher margin of safety you have if your analysis proves wrong. You don’t want to diversify away your opportunity, but having backup systems and contingency plans give you several ways to win. Being fully integrated with all eggs in one basket gives you several ways to lose.

And remember if you’re sitting in the same theatre as everyone else, nodding along to the same sermon—when there’s a rush for the exit—everyone is thinking they’ll get out before you. Like the joke of the bear chasing the two hunters, when one tells the other, “Stop running, you’ll never outrun him.” The other replies, “I don’t need to outrun him—just you!”

A Cynic's Conference Guide to Cleantech & Nanotech

Last week’s nanotech/cleantech event was phenomenally well-attended. Ira Ehrenpreis of Technology Partners makes a persuasive case for “cleantech” and advocated why “green” is the new red, white and blue. Ira was joined by some prominent industry executives. Most of the prior year high-profile investors and startups were busy at work—some with breakthroughs, other falling through.

Before I give a cynic’s playbook for making the most of such events, here’s some straightforward observations:

The cost of capital for any technology for which there’s sufficiently high enthusiasm is close to zero. The two are inversely correlated. This means the marginal entrant has low barriers—which means the number of entrants grows exponentially. This characterizes “solar” today. The ecosystem cannot support the sheer number of companies competing to turn sunbeams into electrons, along the same points of differentiation: cost per watt and efficiency. Companies that got public early will use their stock currency to acquire those with interesting technologies as they postpone their own IPOs, face investor fatigue and eventually falter. It is a predictable pattern in capital markets. And the four most dangerous words are “this time it’s different”. It never is.

The same is said of biofuels—at the event there was growing laments of this arena. And despite what critics say of “Mr. Ethanol” Vinod Khosla—if anyone figures this tough field out, my money would be on him. As a consumer, I absolutely applaud all the alternative approaches being tried and think we’ll be the better for it. As I’m fond of reciting from Jim Surowiecki, “In greed and avarice, lies the hopes for progress.”

Like nanotech a few years ago, the cleantech audience is a mix of investors and entrepreneurs swimming in a sea of service-providers. Year after year the battle of attrition rages fiercer as a few legal, lobbying, accounting and boutique investment banking firms vie for position and client dollars. Today’s cocktail party for me is paid for by tomorrow’s client for them.

The good news for them: the early ones will benefit from client referrals and positive feedback loops. The bad news: the laws of competition don’t cease. The service-provider supply imbalance means only a few remain to pin next year’s shiny translucent name badge to their lapels-- fewer still will get the privilege of affixing the coveted fabric sticker elevating them above the undistinguished masses declaring them “Speaker” or “Sponsor”. Behold.

If you’re a service-provider, here’s your attack plan for success for any new field: for the first two years, come in full force. Senior partners, associates, secretaries—even the janitorial staff. If they can move, dress them up and send them out with business cards. Get their names on the attendee list. Try to make up 10% of the attendees. But remember your competitors might do the same thing, so send people with unusual last names—they’ll stand out more. During breaks, establish position early. Move in a swarm formation, gather in circles and spontaneously laugh. It will attract curious onlookers. Remember: some of those onlookers have investors’ money to spend and it could be yours. Do this near bathrooms and coffee machines. If there is a plate of cookies, take as many as you can, pile them in a napkin, stick them in your pocket. Offer them out to people that look like potential clients. It’s called reciprocity—it works. And everyone loves sweetness.

Sponsor a table. Again, you must stand out. Give away something amazing: like mints—in a tin can. Put your name on it so that everyone knows you’re not just any old service-provider. Try a plastic pen—a good one screams out, “excellence”.

Have a few key lines to show you’re an expert and you know what you’re talking about. If its nanotech, try this: “we’re helping our clients with some major partnerships and helping them build a really strong IP portfolio.” If its cleantech try this: “the debate is over. We need to act.” If someone asks you what debate, look at them despondently and say, “don’t you have kids?” Pull out a picture of yours. If you’re childless, use a polar bear on an ice raft with sad eyes. Mention that you’re carbon neutral, have stopped exhaling and only wash your undergarments every other week to save water—which by the way is the Oil of the 21st century.

Show thought leadership through whitepapers and dole out some witty comments on panels. If the moderator asks you a question you don’t have a good answer for—just answer one you do. The audience only remembers what you look like and how loud you talk—not what you actually say.

When your assault team returns, immediately send emails to all the new contacts you made. Send them a PDF with images of windmills, solar cells, a water droplet and multicultural people shaking hands. It will show you when it comes to cleantech—you mean business. If someone writes to you, start your email message with “Thanks for your note.” Mention that you hope to find “ways to work together”.

Chemical & Engineering News: Venture Funds Turn to Cleantech

Read some of my thoughts on biofuels, batteries, and solar energy in this week's edition of Chemical & Engineering News:
Venture Funds Turn to Cleantech
by Melody Voith

Enjoy!

Vacuums, Pears and Probability

Below is a preview of this month’s issue, but first here’s the thing. Nature abhors a vacuum. And people abhor uncertainty. As social creatures: when we don’t know something, we look to others for clues--even if they’re clueless. As pattern-seeking creatures, when we don’t know something, we look to the past and play the childhood game of ‘Memory’. We internally say, “Hey, that market movement looks just like that market movement I saw before.” It’s only slightly more sophisticated than drooling on ourselves as we grab for the card with the “Pear” on it.

The funny thing about looking to others is this: they’re often looking to us. It can quickly become a recursive hall of mirrors. Like a video camera pointed at a TV screen playing what’s on that video camera. And the thing about markets is this: they only function properly when you have buyers and sellers. And for a buyer and seller to meet, they must see two different things. One is buying something from the other because he/she presumably sees something the other doesn’t. (Maybe they have different information or maybe the magnitude or the duration or the probabilities of some event they are both seeing have different weighting). Liquidity exists only when buyers and sellers see different things. They have diverse views. When they see the same thing and act accordingly, there is a diversity breakdown. And then you get bubbles and crashes.

Now, when it comes to pattern recognition, here’s the rub: past isn’t prologue. There’s a reason it’s called “news”. As Kurt Vonnegut once said, “History is merely a list of surprises. It can only prepare us to be surprised yet again.”

Yet risk and uncertainty are the basis for all pricing and discounting the future—and thus pricing and discounting all assets. Aesop’s Fable nailed it in folksy terms: ‘a bird in the hand is worth two in the bush.”

Increasingly the one thing I know for sure is as that might say in my native Brooklyn, nobody knows nuthin’. And the other thing is that payoff is inversely proportional to expectation. The lower the expectations, the higher they payoff if it hits. And the higher the expectations—well, it’s already all priced in.

In John Maynard Keynes’ “Treatise on Probability” he outlined what would later become better known as the Ellsberg Paradox. It goes like this: Let’s say you have a box with 30 red balls and 60 other balls that might be black or yellow. Without knowing how many black or yellow balls are in the box, you know the total of both is 60. The balls get mixes in the box and you are given two choices. Choice 1: you get $1,000 if you pull out a red ball. Choice 2: you get $1,000 if you pull out a black ball. Around the same time, you’re given another set of choices. Choice A: you get $1,000 if you pull a red OR yellow ball. Choice B: you get $1,000 if you pull out a black or yellow ball. So which would you choose?

Well, you’d pick Choice 1 over Choice 2 only if you thought you were more likely to pull a red ball than a black one. If you thought the odds of pulling red or black were the same, you’d be indifferent. Likewise, you’d pick Choice A over Choice B if you thought that pulling a red OR yellow ball was more likely than pulling a black OR yellow ball. If it’s more likely to pull a red one than a black one, then pulling a red OR yellow one is also more likely than a black OR yellow one. So if you picked Choice 1 over Choice 2, you’d also prefer Choice A over Choice B. And if you preferred Choice B to Choice A, you’d then prefer Choice 2 to Choice 1.

But when asked, most people almost always prefer Choice 1 to Choice 2. And Choice B to Choice The reason: most people prefer known risks to unknown risks. This is called “ambiguity aversion”. Also, the more risk-averse someone is the more they’ll pay to get rid of risk, taking a sure $1 over a 50% shot at $3—even though taking the latter is more rational because it’s expected outcome is higher. Some theorists think this explains why one person could buy both an insurance policy and a lottery ticket—which isn’t as irrational as some might suggest. There are all kinds of variety of other games and thought experiments, like the St. Peterburg Paradox, Martingale Progression, Gambler’s Ruin.

Now, here's a controversial question: What if you didn't have to die? When asked this, first my eyes rolled; then my eyebrows rose. This month be sure to read the special three-way interview in our premium Forbes/Wolfe issue with Aubrey de Grey, who will eventually either prove to be off his rocker or prove to have helped you avoid a rocker in the first place. Weighing in with a more conventionally credible scientific point of view is David Sinclair, Harvard rising-star, founder of recently public company Sirtris and venture partner at my firm Lux Capital. While a "cure" for aging might seem far-fetched, and a "cure" for cancer, less so—a lot of smart people (and the smart money backing them) are trying to turn cancer into a treatable condition like diabetes. Nanotech is front and center attacking cancer like a molecular military, replete with covert and timed attacks, Trojan horses that would make Ulysses proud. Also, you read it here first: One of the great frontiers of technology (both hardware and software) is the haptic interfaces and displays that we react to and interact with. The molecules and materials from Apple's iPhone to Cambrios' touch-screen materials to flexible displays are putting the "active" in interactive. This is an area ripe for innovation and change—meaning it’s also ripe for in-the-know investors to position themselves ahead of others. The future, like information, is here—it's just unevenly distributed. As always, here's to thinking big about thinking small...and to the emerging inventors and investors who seek to profit from the unexpected and the unseen....