As an investor, the way we should identify potential investment opportunities are the ones that offers the value of optionality. Where the investment yields a large upside potential and minimal downside risk. While this may seem like common sense, in reality, not many applies such logic in making an investment decision. Very often, people are swayed with what I call stories otherwise also known as growth prospects. I would like to share with you a joke, an excerpt from Charlie Munger: The Complete Investor.
An investment banker and carpenter are sitting next to each other on a long flight. The investment banker asks the carpenter if she would like to play a fun game. The carpenter is tired and just wants to have a nap, so she politely declines and tries to sleep. The investment banker loudly insists that the game is a lot of fun and says, “I will ask you a question, and if you don't know the answer you must pay me only $5. Then you ask me one question, and if I don't know the answer, I will pay you $500.” To keep him quiet, she agrees to play the game.
The investment banker asks the first question: “What's the distance from the earth to the Saturn?” The carpenter doesn't say a word, pulls out $5, and hands it to the investment banker.
The carpenter then asks the investment banker, “What goes up a hill with three legs and comes down with four?” She then closes her eyes again to rest.
The investment banker immediately opens his laptop computer, connects to the in-flight Wi-Fi, and searches the Internet for an answer without success. He then sends emails to all of his smart friends, who also have no answer. After two hours of searching, he finally gives up. The investment banker wakes up the carpenter and hands her $500. The carpenter takes the $500 and goes back to sleep. The investment banker is going crazy from not knowing the answer. So he wakes her up and asks, “What does go up a hill with three legs and comes down with four?”
The carpenter hands the investment banker $5 and goes back to sleep.
Optionality - After Thoughts
Often, I find that with all the theories we have read, we only gain a better understanding of them through practice. It is the same with the value of optionality that we had a better appreciation of it when investing in the Hong Kong markets. The reason being, trying to invest in Grahamite stocks in Hong Kong is a near impossible task. Investors who have tried would realize that nearly all of these companies that appear on the screener are PRC incorporated ones.
Understanding this, we did not give up hope, but continued searching for companies that traded at low earnings multiples. While such stocks are ideal, such investments do not offer the same sort of comfort as would an investment that is cheap based on assets. It was only till we found a company that was trading at a low earnings multiple but offered us downside protection. Meaning to say, while it was not a net-net, the market capitalization of the company was trading at a premium of 20% to net current asset value. As such, an investment in such a company could be seen as an optionality where we get the upside potential of say 100% for a company of P/E 4.0x to revert back to P/E 8.0x but have a downside protection of 80%.