What's the worst case scenario?

Survival and end of the world scenarios seem to be en vogue.  From the preppers to the impending financial collapse of Japan/China/Europe/US there's a very vocal subset ready for a collapse of something.  Investors are preparing for another market crash, and it seems like journalists are writing about bubbles to capture page views.  I'm not sure if doomsday has always been so popular, but it's been something I've been thinking about recently.

Last week I drove up to Toronto to attend the Fairfax shareholder dinner on Tuesday night.  At the dinner we had a chance to listen to various Fairfax executives discuss their company and issues they felt were important.  One executive discussed her view that China is on the verge of an impending collapse.  Fairfax Financial in general is bearish on both the market and various countries, they predict that we'll experience deflation along with a Chinese implosion.  Their outlook is very dire, and it's not an uncommon view held by investors.

While I was listening to the Fairfax executives discuss China I started to think about a friend of mine.  He is a former survival instructor in the Air Force, he'd take students into the woods and show them how to kill game, find water and survive enemy tourture techniques.  I was always fascinated by his stories about eating goat eyeballs or being dumped in the desert without water, the training was intense.  Beyond his survival skills my friend also has a keen sense of business opportunity.  After leaving the Air Force he and his wife started one of the first drive through coffee shops in Pittsburgh.  It was no surprise when he wrote a book catering to the prepper movement based on his Air Force survival training.  For my foreign readers who need a little background; preppers are Americans who are scared about terrorists or a revolution, or nuclear attack who in response have fortified their house, stored food, and train to thwart attackers.  The prepper movement has spawned TV shows, books, and training courses to prepare for some terrible event.

My friend wrote a book about an EMP attack in the US.  I haven't read the book personally, but I'm familiar with it.  In the book civilization breaks down as a result of this attack and Americans are forced to fend for themselves.  The book is part survivalist manual, and part story.  From this launching pad my friend started a consulting business and is now in the business of writing other material for the prepper niche.  I doubt he ever thought he'd be making a career out of experiences from the Air Force, but he saw opportunity and took advantage.

I find the societial collapse scenarios and obsession fascinating.  There is a whole plethora of scenarios that could potentially take America from eating McDonalds and drinking Coke to fighting each other in the streets, growing food and living in some anarchist society.

Story lines for a societal collapse remind me of story lines for market collapses.  If A happens then it will lead to B, which in turn leads to C, which results in D, after which we're all living in huts with loin cloths and grass skirts.  The problem is outcomes are never as neat and tidy as the story lines we tell ourselves.

What's intriguing about all the collapse scenarios is that although we have a lot of stories and theories of collapse if one looks back in history there aren't that many examples of a total collapse.  There are examples of governmental breakdown and disorder in societies, but none that I know of have led to people living as they did in the stone age.  I'm astonished at the number of groups pushing for a total collapse.  From environmentalists preaching about our energy usage, to right-wing militias it seems like each of these groups has an agenda to push.  Each group is selling something, and if we don't adopt all of their changes we are led to believe we'll experience a worst-case scenario.

For some reason humans are attracted to the worst case scenarios.  We want to be worried about something remote and unlikely to happen.  We're worried about an EMP explosion (do they explode?) that knocks out the electricity grid, but we're not worried about unsafe drivers on the roads.  We're worried about China collapsing and destroying the market, but we aren't worried about buying into an over-levered company with a dying business model.  We over estimate remote risks, and under estimate reasonable risks.

Evidence to support this can be viewed in the comments on this blog.  Many commenters have posted very valid worst case scenarios about companies as a reason to avoid the investment.  The worst case scenario sounds attractive, and it's easy to buy into the story line, but is it relevant?  If you look back at a lot of those worst-case scenario comments you'd see that the scenarios never materialized, rather a much better scenario unfolded.

When a company is trading close to or above a fair value a lot of things need to go right, or continue to go well in order for the company to grow into their valuation.  Sometimes a company does everything right and a seeming overvalued turns into a missed buying opportunity for investors.  There really are companies out there that can grow sales 25-50% a year for stretches, I've worked at one in the past.  Growth like this doesn't last forever, but it lasts long enough that a high valuation can be deserved.  Just like there are star athletes, there are star companies that make all the right decisions for a period.

When a company trades for a low valuation not many things need to go well.  It's the opposite, as long as a company avoids failure or disaster they are often worth more than what the market is pricing them at.  Valuation trumps risk, at some point a valuation will be so depressed that even the most unpalatable prospects can be enticing.  I know investors will disagree on this point, but outside of purchasing nuclear waste or something toxic like that I'm guessing that most investors would take even the worst business in the world if offered for almost nothing.

A lower valuation protects an investor against terrible outcomes.  Competitive advantages, and concerns about a moat disappear as a stock's valuation drifts lower.  Below a certain point if the company continues to simply conduct business they are worth more than their valuation even if the market disagrees.  What seems to happen is the market latches onto worst-case scenarios and ignores more likely near term scenarios.

Humans are incredibly creative and able to react in unpredictable ways to situations.  Investing in companies with extremely low valuations is akin to betting that we will witness human ingenuity.  When a company is facing dire circumstances often management will do uncharacteristic things in order to both save their jobs and save the company.  Sometimes those actions work, not always, but enough.  Othertimes conservative management can be forced out of their comfort zone when competition is at their doorstep.  A previously sleepy company catches the growth bug and both management and investors are rewarded.

Human ingenuity and creativity are part of the reason I don't buy into worst-case scenarios.  When we start heading down a bad path few sit by and let events run their course.  Our normal response is to do something and try to fix the situation.  When a country heads towards collapse a group of citizens will step up and attempt to fix the situation, altering the course of events.  Companies are no different, few management teams sit by idly as a company falls apart.  It's the action that people take that creates unpredictability in our story lines.  Suddenly the A->B->C->D story line is disrupted because between B and C people stepped in to do something.  Sometimes a fix works, othertimes it doesn't, but it always alters the storyline.

When we buy into companies or countries at high valuations we are implicitly betting that a best case scenario will unfold.  If it doesn't then we are at risk of losing money.  When we invest in a company or a country with a low absolute valuation we are betting that human ingenuity will attempt to do something, and that we'll avoid the worst case scenario.

I look at a lot of companies that the market and investors have written off as worthless.  Many are worthless, they have management teams working to extract all of the value for themselves while the company coasts to zero.  But some aren't worthless, investors might have fears about them, but at a low enough valuation these fears can be overcome.  Absolute valuation is critical, keep that in mind and risk will fall into place.  Items that are risky at 2x BV and 30x earnings are non-issues at 50% of BV and 3x earnings.  Focus on what's likely, not the unlikely worst-case scenario.  And lastly when buying something at a depressed valuation realize that you're making a bet on human creativity and ingenuity to do something to resolve the situation.  The response might not be perfect, but nothing in life ever is.  A reaction doesn't need to be perfect, it just needs to be good enough to avoid the worst.