Degree of Difficulty

There are no extra style points in investing

Sep 23, 2023

a close up of a swimming pool with water — Photo by Markus Spiske on Unsplash

I was recently talking to a friend about a stock that will remain nameless. However, it was a totally busted SPAC that is down over 90% since its IPO and is facing a de-listing notice from an exchange. On top of that, the company is running out of money and is considering a dilutive financing. Oh, and the company is wildly unprofitable, despite achieving substantial revenue growth since going public and in spite of software-like gross margins. Did I mention yet that there is also an operational turnaround required? The company has clearly been (mis-) managed for growth at all costs with the hope that it would garner the gaudy revenue multiples that its much larger scale public comps trade at. When my friend asked me what I thought, my response was, “sounds like a hard way to make money.” The reason has to do with degree of difficulty, a concept that I have begun to think much more about before making an investment.

Anyone who knows me, knows that the last thing I am is someone who is skilled at jumping off a pool from a 20-foot diving board. Swimming is not really my thing and neither are heights for that matter. The reason I bring up diving is that I once listened to a podcast from Wharton Professor and author Adam Grant where he discussed his career as a serious competitive diver. I guess I haven’t watched enough of the summer Olympics because, in that podcast, I learned (or maybe was reminded) that divers can receive extra points from judges for attempting more difficult dives. Are you willing to try a reverse 1½ somersault with 4½ twists off the 3-meter board? If so, the judges will give you extra credit for trying such a feat, even if you don’t execute perfectly.

Given the way my brain is wired, I started thinking about how the concept of degree of difficulty could be applied within the investing context. The idea that sprung into my head was that there are no extra style points for going into an investment with a high degree of difficulty when it comes to being successful. If you make a 15% IRR on a busted SPAC that needs capital and has been totally mismanaged, you don’t get any extra kudos or fees from your investors than if you made the same IRR owning Tootsie Roll, which is potentially the simplest business ever to understand. At my former firm, we used to fill out what we called decision process spreadsheets for every idea for which we did a certain level of research. Think of it like a checklist that standardized the research process across analysts and companies. Within that spreadsheet, there was a question that asked, “Would you rather own Tootsie Roll?” More precisely, is this an investment that requires a lot of things to go right, and, as such, wouldn’t you rather own a very simple business like Tootsie Roll?

If I were being self-critical, I would say that I didn’t devote enough time to contemplating the nuanced implications of that aforementioned question. Because I sure got myself into some difficult situations during my tenure. I have since been afforded the luxury of some time to self-reflect on past mistakes and one conclusion I came to was that I thought about the path to making money in a stock in too linear a fashion. Or, maybe it was that I underestimated the complexity associated with companies achieving multiple goals at the same time. What I learned the hard way is that it is not 2x harder to solve two problems than it is to solve one—it is more like 5x harder. Why is that? There are probably a number of reasons and it is not the same in every situation. But, off the top of my head, it likely has to do with a mix of competing priorities, a lack of institutional buy-in, poor incentives, limited bandwidth, insufficient capital, and probably a bunch of other people-related issues.

When you are an outside investor, it is easy to think of achieving multiple goals in isolation or as if they can be checked off in one-by-one fashion. However, after about 15 years of being a professional investor, I have observed that it often isn’t that simple. People have to prioritize certain things over others and there is chance that there are people working at the company who don’t care anywhere near as much as you do about the stock price. Further, when faced with the task of solving a multi-variate equation, maybe some employees give up or become de-motivated, especially if their stock options are under water and they are not likely to get a bonus. They are probably more focused on getting their resumes ready for their next gig.

Please don’t misunderstand what I am saying here. I am not denigrating the efforts of people who work at the companies I have invested in. For the most part, my guess is that people were working their tails off to remedy what was broken. I am simply trying to be realistic. My inspiration can when I interviewed Markel’s CEO, Tom Gayner, on Compounders. In that discussion, I asked him what he has learned from being a CEO that he could not have learned from being solely a Chief Investment Officer. His response has stuck with me since then. He said that he learned to be more empathetic and understanding when things weren’t going well or when mistakes were made. He also said he had become more patient. The reality that a lot of us in the investing community dismiss or neglect is that the companies we put capital with are made up of people with families, lives, personal problems, and their own definitions of success. As such, we shouldn’t be surprised if change takes longer to happen than we would hope—or never occurs at all.

Make a list

Maybe an example would make this concept more concrete and approachable. I have been very public about the mistakes I made with Lumen Technologies. It has been a terrible investment and I regret so much about the time I spent on it and the people who lost money following my lead. I don’t know if making a list of all of the things that needed to happen for me to make money on Lumen would have saved me from making the investment. But I definitely want to make sure that I don’t make the same mistakes in the future. So, from now on, I am going to write down all of those factors in an attempt to better quantify the degree of difficultly. Regarding LUMN, I now have the benefit of hindsight but even without that this laundry list should have been enough to make me pass:

Gracefully handling a secular decline in the wireline business
Building a new fiber business in a very competitive environment
Navigating through a management succession plan
Cutting costs throughout the organization without negatively impacting growth
Paying a large dividend to investors who expected it would continue to be there
Fixing a bunch of technical debt that has existed for years
Managing a balance sheet that had too much leverage
Selling key assets at multiples higher than the stock was trading at—and not realizing punitive taxes
Properly maintaining the physical plant despite declining revenues
Investing enough to get the enterprise business growing again
Keeping people motivated and working at the company despite a declining stock price and sagging revenues

I could probably go on—but those are the first eleven that come to mind. The point is that very few organizations can do all of these things at the same time. And if they try, they probably fail at all of them because there aren’t enough hours in the day or dollars in the bank for all of these items to be addressed at once.

A cheap valuation won’t save you

Throughout my entire time owning Lumen, it traded at what seemed to be a pedestrian valuation, especially relative to my (mis-) perception of the value of the enterprise business. We used to joke at my old firm that, “you can’t flatten a pancake”, the implication of which is that there is a point at which a stock’s multiple can’t go any lower. That may or may not be true, but is certainly the case that revenue, EBITDA and free cash flow can continue to decline, and even if the multiples stay flat, the stock will go down commensurately. The idea that I am trying to get across is that if the list of things a company has to get right for equity holders to make money is as long as the one above, a discounted valuation is unlikely to provide a sufficient margin of safety. The degree of difficulty is simply too high.

The response to these ideas I would expect to get from deep value devotees or investors who focus on distressed assets is that: complexity breeds opportunity, messiness keeps other investors away and levered companies especially present situations with asymmetric return profiles. In other words, while there are no extra style point awarded for investors who attempt very difficult dives, the potential IRRs are much higher. No one is going to accept a 15% IRR on LUMN given the challenges. Investors are only going to run into the burning building if a position is likely to be a multi-bagger if calamity is avoided. Accordingly, comparing an investment in Lumen and Tootsie Roll is like comparing apples and chocolates. Different investors will seek investments with with different risk profiles. That’s what makes markets work.

I don’t disagree with any of that. Some investors may willingly risk getting zeroed out for the opportunity to make 5x. That is just now how I choose to spend my time these days but for sure the siren song of huge upside potential kept me invested in Lumen for far too long. The nuance that I would propose is that investors should spend their time thinking about the probability of success and the expected value associated with high degree of difficulty investments. In insurance parlance, in my experience, such investments have a high probability of loss, as well as a high severity. As an insurance company, those are precisely the policies you don’t want to underwrite (unless you get insanely good pricing). What I have witnessed is that situations that require companies to walk, chew gum, read Shakespeare and whistle a Mozart piece—all at the same time—have a low probability of being successful. On top of that, for my tastes, if there is a 20% chance of getting a zero, even if the expected value is high, I am going to pass. And to mitigate the risk of getting into situations like the one I dug myself into with Lumen (and Viasat for that matter), I am going to replicate the list above for every new investment, with the ideal list having a single bullet point: