The Turkey Fallacy
MT Capital Research Musing #4
Welcome back to MT Capital Research! If you’re new, join a group of 11K+ Informed Investors who receive frequent reports on the World’s Most Interesting Companies by subscribing below:
MT Capital Research is a reader-supported publication. If you want exclusive access to monthly reports on companies I believe warrant attention, consider upgrading below ($6/mo). My next writeup will be on a company with 60%+ EBIT margins that is bound to benefit enormously from an environment of continued volatility. Stay tuned for that!
Let’s get started.
Throughout a turkey’s life, almost every day will be an affirmation of its wellbeing. If treated in a humane manner, they will wake up, have enough to eat and drink, go to sleep in a safe location far from the carnivorous stares of predators, and repeat the same process again the next day. Despite benefitting from what appears to be a pretty sweet arrangement, likely a short time before Thanksgiving or Christmas they won’t be so lucky. Something unexpected will happen that the turkey’s previous experiences did not prepare it for, and they will likely find themselves becoming a key constituent of people’s holiday celebrations. When illustrated graphically, the turkey’s wellbeing with respect to time would look a little something like this:
In a beautifully simple manner this fallacy, originally brought forward by Nassim Taleb within his stupendously useful Incerto Series, outlines the troubles that may arise when one assumes that the future will behave in an identical manner to the past. Applied to the world of finance, there is clearly no shortage of entities with existences that are just plain turkey-like.
The most obvious example are option sellers. Options, in essence, are a contract that exists between two parties to either buy or sell an underlying assets at a specific price at a particular date in the future, existing as either call options, which gives the holder the right to buy an asset at a certain price at a particular point in time, or put options, which give the holder the right to sell an underlying asset at a particular price at a particular point in time. In exchange for these contracts, the buyer will pay an option premium, i.e. the amount an investor needs to fork over to the seller in exchange for receiving the option. Being that in most instances the market behaves in a relatively range-bound manner, most options expire worthless. As a result therefore, the strategy of selling these instruments, akin to any good insurance operation, tends to be profitable the majority of the time.
Using an example to drive this point home, let’s say I wanted to benefit from this phenomenon, and sell an option in order to collect the premium. In this situation, I decide to sell a call option on an underlying equity with a strike price of $2000 in exchange for a premium of $5. If the underlying asset is lower or at the $2000 price by the time the option expires, I will be able to profit and keep the $5 premium I sold the option for without incurring a loss. However, if the underlying asset trades above $2000 at the time of option expiry, the option holder would be in the money, which entails that I, the option seller, will theoretically be on the hook for near infinite losses, since the underlying technically has uncapped upside.
We’ve now arrived at the problem here. Even despite the fact that the majority of the time options expire worthless, there are a small handful of instances where an unexpected event occurs, and the option seller is exposed to a horrific loss. Although this example is relatively crude in nature, seeing as it assumes that the selling of options is done naked, it illustrates a turkey-esque fallacy. Over time, the seller of options will likely collect premium and profit steadily, however, there is bound to be a day where this is not the case, and if improperly diversified and hedged against, these positions may result in an enormous blowup following suit.
Over the last few decades, there are numerous examples of this behavior playing out in real time. One of the most notorious was Long Term Capital Management, a hedge fund that was started by renowned wall-street traders and economists, some of which funny enough came up with the black-scholes option pricing method. Outside of their bond arbitrage portfolio, the firm engaged in a series of other strategies, such as putting on positions that were essentially short index volatility, all done with spectacular amounts of leverage. Techniques that seemed so infallible for years eventually proved to be disastrous, and a surge of volatility attributable to the 1998 Russian debt default and subsequent currency devaluation resulted in the majority of LTCM’s value being eviscerated in the span of a few days, happenings that would spur on the Federal Reserve to arrange a bail-out to eradicate the threats that this event supposedly posed to global financial market stability.
Another great example is the infamous optionsellers.com, a former Florida-based hedge fund whose strategy should come as no surprise after reading its name. For years, in the early 2010s, the firm capitalized on suppressed volatility in certain energy markets, particularly crude oil and natural gas, phenomena owed to the surging levels of shale production, of which was mitigating supply shortages and therefore damping volatile price movements. As one might imagine, with volatility suppressed, selling options worked wonders, and the firm was able to continuously collect premium. Despite this early luck, the tide turned in 2018. The firm had entered into the year having sold options on both crude oil and natural gas, positions that quickly turned against them after years of relatively serene waters reversed and turned choppy, essentially in an instant. With a surge in volatility, a meteor-sized hole emerged in the company’s balance sheet, and it would succumb to these wounds a few days thereafter.
As we make our way through 2023, there have been numerous instances playing out so far this year that are clearly turkey-fallacy-esque. Whether it be with SVB that hoped for the best while essentially going all-in on a generational top in the bond market, investing in long-dated treasuries without a sliver of concern over the potential ramifications of the duration risk that this decision posed, or some growth companies that operate in a manner akin to an episode of the walking dead, failing to generate enough EBIT to cover interest expenses with rates near-zero, let alone near 5%, foundations of some of the last decade’s darlings have clearly started to crack, and in some occasions, outright disintegrate. The nature of the operations of innumerable entities are being exposed for what they really are, sellers of options on interest rates, of which collected premium for years hoping that we would not enter into an environment where there is a real cost of capital. As markets continue to traverse an increasingly uncertain environment, one where the potential for continuously tight financial conditions and draining liquidity threatens to continue to choke off the oxygen of businesses that arguably shouldn’t have existed in the first place, we may very well see more turkeys in the news.
My focus from a portfolio construction perspective will continue to be centred around investing in companies and other asset classes whose operations/general existence are intertwined with a degree of embedded resiliency; ones should be able to both navigate and thrive no matter what type of macroeconomic regime we may find ourselves in. If this interests you, stay tuned for my future pieces.
Beware of hidden turkeys.
Until next time,
MT Capital Research.