On Fragility & Optionality

• Fragility from excessive debt.
• Fragility from absence of entry of barriers.

1. Unable to prevent competitors from taking market shares. (exceptionally prone are high margin gadgets)
2. Patent protection is not a source of competitive advantage.
3. First mover is not a source of competitive advantage.

• Fragility from likely disruption.
• Fragility from dependence.

1. High customer concentration
2. High supplier concentration
3. Dependence on debt/equity market
4. Protectionism(subsides from government)
5. Outsourcing of manufacturing supply(Nvidia). Although this leads to high margin in the short run, might lead to future competition from it outsourcers.
6. Dependence of commodity price.

• Fragility of the low margin business.

1. High input prices
2. No pricing power
3. Easy to slip into losses if something unforeseeable changes.

• Fragility from hidden structural risks

1. Responsible for liabilities even if the company is not negligent(PG&E)

• Fragility from a rigid cost structure.

1. High operating leverage.
2. High fixed costs(Airlines)

• Fragility from Asset Liabilities Mismatch.

1. Long term assets funded with short term borrowing.(LTCM)

• Fragility from the presence of multiple independent risk factors.

1. 90% chance an undesirable event won’t happen during year. 4 such independent events. What’s the chance that none of these events will occur during a year.0.9*4=65.6%
2. What’s the chance that at least one of them will happen during a year.1-65.6%=34.4%
3. What’s the chance that at least one of them will happen sometimes during the next 5 years?1- probability of none of these events occurring sometime during the next 5 years 1-(0.3439)^5=99.52%

• How to avoid fragility?

1. Avoid
2. Position sizing
3. Uses a lower valuation

• Fragility model is a series of win followed by a huge loss.
• Optionality model is a series of loss followed by a huge win.