Resilience

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A farmer feeds his chicken every day for 999 days. Each day reinforces the chicken’s belief that the farmer is his friend. But on the thousandth day—Christmas—the farmer greets the chicken with a hatchet instead of feed.

This doesn’t just happen to chickens.

John Meriwether, the former head of bond trading at Salomon Brothers, founded Long Term Capital Management (LTCM) in 1994 with Nobel laureates Robert Merton and Myron Scholes.

The fund bet on the convergence of bond prices. The deviations were small, so they used leverage to amplify their returns. LTCM started with $1.3 billion of capital and grew it to $4.7 billion in 1998. They leveraged that 25 times to support $125 billion of assets and over $1 trillion of notional derivatives exposure.

LTCM made 28% (net) in 1994, 21% in 1995, 43% in 1996, and 17% in 1997. They hardly ever had a down month, let alone a serious drawdown. Like the chicken, a long string of consistent profits reinforced LTCM’s confidence that they were safe, right up until they blew up.

On August 17, 1998 Russia defaulted on its debt, causing a flight to safety that forced credit spreads to widen. LTCM lost 90% in two months. The Fed orchestrated a $3.6 billion bailout to save the financial system from contagion.

Past performance, it turned out, was not indicative of future results. Years of stable returns created the illusion of safety and masked LTCM’s inherent fragility. The same could be said of Enron, Bear Sterns, Lehman Brothers, First Republic, and Silicon Valley Bank, to name a few.

“People are very good at forecasting the future,” wrote Morgan Housel, “except for the surprises, which tend to be all that matter.”

Investors often mistake smooth financial statements for resilience and safety. Extrapolating the past into the future is natural and appealing. We do it almost automatically and unconsciously, but it can be a dangerous habit in markets where “hundred year floods” seem to happen every five or ten years.

In a world where unusual and unpredictable things happen all the time, resilience is a critical quality to have in an investment.

Resilience is the ability to resist shocks and stay in the game. A resilient system withstands disorder and returns to its prior state. Think of it like a rubber band snapping back into shape after being stretched.

Resilience is a universally desirable investment quality because without it nothing else matters. Anything times zero is zero, no matter how large or small. I don't know anyone that wants their investments to be more fragile.

Despite its importance, investors don’t talk about resilience often. Perhaps because resilience is hard to spot.

Resilience doesn’t show up in financial statements or spreadsheets. Consistent sales growth, steady margins, and a high return on equity are wonderful, but don’t indicate resilience. Just ask Silicon Valley Bank.

Resilience is only clear in hindsight, and even then it can be hard to see. Every crisis is different, and it's easy to fall into the trap of the generals fighting the last war. Surviving the last crisis can give us clues, but not guarantees, about the future.

We can hypothesize that a business is resilient, but can’t know for sure until it is tested. The biggest risk is always what no one sees coming, so it is difficult to anticipate what a business needs to be resilient to in advance.

Ironically, when a business is resilient, it may look like nothing much happened at all: the factory didn’t close, the dividend didn’t get cut, the margins didn’t implode. There was no drama, no headlines, no bailout. To the casual observer, it might seem like the business was never really tested—when in fact, it passed the test quietly.

Resilience may be difficult to spot, but its opposite–fragility–is not. To paraphrase Charlie Munger, avoiding fragility is easier than seeking resilience. Does the business depend on a key customer, supplier, or platform? Does its future hinge on a regulator’s decision? Could a government decree suddenly break the business? Is the balance sheet overleveraged? Does the company have pricing power? Is its product subject to obsolescence?

These are the typical questions you see on investor’s checklists, and for good reason. Avoiding the obvious signs of fragility is a good start, but spotting true resilience requires a broader strategic view of the business.

Biology and engineering offer some of the clearest examples about how real resilience is built. In both fields, resilient systems rely on redundancy, optionality, and decentralization.

Humans have two lungs, two kidneys, and two eyes for a reason. Airplanes have two engines, and the internet has many nodes. Bridges and buildings are built to support far greater loads than are ever expected. Redundancy looks inefficient during good times, but becomes indispensable during the bad.

Resilient businesses need multiple product lines, multiple sales channels, and multiple suppliers. They may even be vertically integrated to ensure a steady and high quality supply of raw materials. They have extra cash and inventory on hand to meet unexpected needs. This usually looks inefficient, but occasionally looks brilliant. Just in time supply chains look great, until they break when you need them most.

Redundancy provides optionality, and optionality allows business to adapt to changing conditions. Charles Darwin wrote, “It is not the strongest of the species that survives, but the most adaptable to change.” Predicting the future is impossible to do consistently, but managers can prepare for inevitable changes by building optionality.

Businesses with multiple suppliers can shift volumes to skirt tariffs or natural disasters. Businesses with “good, better, best” product lines can still serve customers trading down during recessions. Businesses with excess inventory can continue serving customers during a shortage. Businesses with excess cash can invest through a down cycle when prices are lowest and returns are highest.

In Antifragile, Nassim Taleb wrote, “Optionality is a substitute for intelligence.” because having options your competitors don’t can make you look like a genius. The real genius is building redundancy and creating optionality ahead of time.

Systems are stronger when risks are decentralized and distributed, not concentrated. Resilient businesses are built like the water-tight compartments on a ship: several can fill with water without sinking the boat. Any single McDonald's restaurant or franchisee can fail without affecting the whole. A business should be able to lose any single customer, supplier, factory, manager, or court case and continue on.

Decentralized systems also push decision making to the front-line employee. Sales people know what customers want, not C-suite executives. Line workers are most capable of seeing defects and fixing the source, not the engineers who visit the factory once a year. Decentralized decision making makes businesses more agile and adaptable.

Resilience does not happen by accident. It is the result of deliberate actions to install redundancy, optionality, and decentralization into a business. In this sense, management and culture are the root source of resilience.

Actions that increase resilience cost money up front, like an insurance premium. Since resilient businesses pass their tests quietly, the benefit of the investment may never be obvious. Survival is the real prize.

Resilient businesses are almost always built by owner-operators—those with their own savings, reputations, and futures tied to the survival of the business.

True owners think in decades or generations, not quarters or years. They are willing to bear the upfront costs of redundancy because they understand that enduring minor inefficiencies is the price of long-term survival.

Hired-gun CEOs, whose tenures are measured in years and whose rewards are tied to stock performance have little incentive to make such investments. Building resilience reduces immediate profits, introduces slack that analysts criticize, and demands painful patience—things professional managers rarely have the luxury, or the motivation, to prioritize. Without skin in the game, the hard trade-offs necessary for resilience are almost always postponed or ignored.

Warren Buffett says that it is only when the tide goes out that you see who has been swimming naked. It’s a funny quip, but scary when you realize that most people don’t realize that they’re the ones swimming naked. The Nobel laureates at LTCM sure didn’t, let alone the chicken. Resilience doesn’t happen by accident, so if you are not actively building resilience into your investments and your managers are not building it into their businesses, you might be swimming naked too.

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