Altus Insight - October, 2013
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Up until a couple of days ago I thought I was going to have to beg out of writing a monthly article. In addition to normal business operations, the entire Altus team, myself included, has been extra busy doing the legal and groundwork for the Multi Tenant Income Fund we will launching shortly and I hadn’t taken the time to prep anything for discussion in an article. But then I received an email from a gentlemen named Ben Hunt who writes through his website at EpsilonTheory.com (click here) . In his email on the 20th of this month he wrote about a topic that many of us may subconsciously have some understanding of, but if you are like me had never brought it to the forefront of consciousness for discussion. With apologies to Mr. Hunt for his text being the basis for mine, I will try to put an alternative asset lens on the line of thought so that it might help us in our own investment activities.
Game Theory currently plays a huge part of the decision making processes for many investment professionals and is the foundation for Mr. Hunt’s writings. The basis of Game Theory is trying to understand how other participants in “the game” may act given a certain set of circumstances and then make decisions for play based on the expected decisions of the other players in the game. As Mr. Hunt pointed out, there are three forms of basic game theory decisions; decision making under certainty, decision making under risk, and decision making under uncertainty. The first two scenarios are pretty easy to understand. Decision making under certainty is just that, making decisions based on known information, like water will boil if enough heat is applied. Decision making under risk is when there is unknown information but the unknowns are quantifiable. An example is the game of poker. The cards in the others players’ hands are unknown, but the odds of those cards being able to beat the cards in your own hand have a certain indisputable probability, though in most real life decisions the unknown risks are much harder to quantify. Decision making under certainty can be described as things we know we know and decision making under risk can be described as things we know we don’t know.
The third Game Theory decision type is where things get interesting and where we as investors can get ourselves in the most trouble. Decision making under uncertainty pertains to the things we don’t know we don’t know. The 9-11 terrorist attacks are an extreme example of an event that shook the economic world and completely caught investors by surprise. Risk is inherent in investing and with an understanding of an investment’s related risks an appropriate return structure can be calculated to assist in the buy/no buy decision (or vice versa the sell/don’t sell decision). Uncertainty doesn’t allow for the same calculation because it is, as aptly named, uncertain.
The key take away of the above couple paragraphs is that RISK and UNCERTAINTY are not the same thing. We often use them interchangeably but in decision making their meanings are quite different.
The current age of deleveraging the world economy is experiencing, or at least trying to experience, is not unique from a historical perspective. There are many instances of governments or populations taking on far more debt than was wise, that debt passing the point of being useful and becoming a burden to growth, and then the painful experience of unwinding that debt at the expense of economic growth and prosperity. Generally those periods of over indebtedness were the result of war but there are cases, the current deleveraging included, where the debt is due to a society living beyond its means. By studying history economists can determine probable economic outcomes. From an investor’s standpoint this would be a known unknown.
However, given the unprecedented actions of the Federal Reserve and other organizations (ECB, BOJ, BOE, etc), the reality is that no one can venture a guess as to the timing or severity of outcomes associated with the deleveraging. This is an unknown unknown.
The differences of the two situations above are important to understand. In the first the risks can be mitigated by various investment structures and/or hedges but in the second, since no really knows, investors can only guess as to how to invest in such a way to maximize returns or preserve capital. Some people may be able to put together persuasive arguments as to the possible outcomes but no probabilities can be placed on those outcomes.
While major economic uncertainties also affect alternative investments (ask investors in residential land development in 2007), there are alternatives (pun intended) that can produce returns while creating positions to survive or even prosper during a variety of possible economic outcomes, even if the probabilities of those outcomes are unknown. The key is needs dependent cash flow (housing, food, water) from real assets and/or positions in real assets with no debt. Using the 9-11 attacks as an example, stock traders got destroyed as investors rapidly pulled money out of the stock market. Responsible apartment owners may have had to deal with an increase in vacancy but they continued to collect rent checks every month. The same is true with the more recent crash in asset values that started in 2006 and ran through 2009 (and specifically Fall of 2008 for the stock market). People that depended on price appreciation for their returns were annihilated while those that had positions based on cash flow did considerably better. This is especially true for investors that held those cash flow positions with little or no debt.
In real asset alternative investing, specific investment uncertainty, or opportunity specific unknown unknowns, may be a much larger concern. Thankfully, when it comes to specific opportunities “uncertainty” can be turned into “risk”. This can be achieved in several ways
1. Education – Smart alternative investors spend the time and money to learn what questions to ask. A question asked is a question for which an answer can be found (turning “uncertainty into “risk”). The unasked question goes unanswered.
2. Research – Any alternative investor can spend the time to do research to understand a specific investment opportunity, whether that research is on geopolitical trends, local business conditions, or management capabilities. Education may teach a person which questions to ask and where to go for answers but research is the follow through required to turn those unknown unknowns to known unknowns, or even better, to known knowns.
3. Team up/Piggy back: There are many investment organizations where alternative investors can go, not only for exposure to opportunities they may not have otherwise seen, but also for education and networking. By co-investing with other members of these organizations members can leverage one another’s expertise in research. Of course, this makes the assumption the other investors are knowledgeable and willing to expend the effort on the research, which is not always a good assumption. That being said, we have had several investments made into our various funds by people who depended on the research and recommendation of a lead investor. Angel groups are especially adept at such arrangements.
4. Management - As a younger principal/sponsor in alternative asset projects I disliked it when investors would harp on my lack of experience. Now that I have more experience I can understand why they focused on this, but I believe they were misguided in their concerns. Experience isn’t what makes someone a good investor. Experience only provides learning opportunities, but it is only through actually learning from those experiences that we become better investors. Some people learn not to hit their finger with a hammer after only smashing themselves once. Other people may not learn the lesson for two or three or ten times, and there can be a variety of reasons for this (usually centered around pride and/or lack of self- awareness). The most successful investors avoid smashing their finger because they are willing to learn from the experiences of others. To me management comes down to four things:
1. The level of knowledge, resources (human and knowledge capital), and willingness to ask for help.
2. How does the management react when times are rough?
3. Unlike investments into securities, most alternatives (at least real asset alternatives) involve a lot of moving pieces and human interaction, so a person’s ability to cooperate with employees, other investors, suppliers, customers, etc. is important.
Please note that finding out a management team doesn’t have the knowledge base, interpersonal skills, etc. I would like them to have doesn’t necessarily make an investment a bad one. It simply changes the risk associated with that investment. The management becomes a known unknown (or even known known). However, if I don’t do the research or ask the questions then any management shortcomings remain as unknown unknowns and therefore can’t be calculated into an investment decision. If I had one question to ask management it would be “Tell me about a time that things didn’t go well for you, what was the outcome, and how did you deal with other parties involved in the situation?”.
Unfortunately it is impossible to eliminate all uncertainty from our investing, and it is certainly impossible to eliminate all risk, however, with vigilance we can move unknowns to knowns, and in so doing greatly increase our chances of success.