This would be a two part series, where we first cover on the kind of investments we are constantly searching for, followed by a case study on our investment in Petrobras that we have recently exited out position from.
What are Asymmetrical Investments?
An asymmetric payoff (also called an asymmetric return) is an investment strategy where the upside potential is greater than the downside risk
— Wikipedia
In the nutshell, they are investments where we are paying 30 cents on the dollar, where the amount we stand to gain is far greater than the amount we will lose. An example would be when Klarman made an investment in bonds of a company that was affiliated with AIG during the Global Financial Crisis. The company’s bonds were trading for 20-30 cents on the dollar. While these bonds were trading at a discount of 70-80%, they were actually scheduled to pay investors back at par value just a week later.
Risk Management
Ideally, we are able to find such asymmetrical payoffs in large-cap companies that we are all familiar of. However, the hard truth is that it isn't the case. More often than not, such payoffs only exists in the low quality businesses – companies that have been rejected, under-followed and unheard of. Hence, risk management is a crucial step in our analysis as to finish first, one has to first finish. This is where the famed phrase due diligence is required. Very often, I have seen people getting ahead of themselves in terms of the growth of the company / potential upside / amount of cash, that they fail to read the footnotes or fine print.
Probability of Success
Having mentioned that these companies are trading at 30 cents on the dollar, one has to assess the probability of both outcomes. Investing as such is similar to poker, where we play our hand only if the odds are in our favor. Hence, establishing the probability of the upside versus downside scenario is another crucial step. A probability of a 10% upside scenario versus a 90% downside scenario, is equivalent to going all in with just pocket ‘2's. Establishing that there is an asymmetrical payoff has to be coupled with assessing the probability of each scenario happening.
Summary
At the right price, even a low quality business can be a solid investment. However, extreme due diligence is required as determining risk is not always very obvious. Very often, these companies are shunned by the majority for a reason and only rarely do we see cases like the ones mentioned above where we are throwing the baby out with the bath water. In the next article, we will be discussing a case study on our investment in Petrobras.
