Insights_AntifragileBarbara Gray, CFA – January 31, 2013 – Since I read Nassim Nicholas Taleb’s new book “Antifragile: Things that Gain from Disorder” over the Christmas holidays, I have been thinking more and more about how it relates to our social capital investment thesis. “Antifragile” builds on the ideas Taleb introduced in his highly prescient book “The Black Swan” published back in 2007 that talks about how highly improbable and unpredictable events can have a massive impact. He starts by talking about the concept of fragility “I suddenly realized one day that fragility—which had been lacking a technical definition—could be expressed as what does not like volatility, and that what does not like volatility does not like randomness, uncertainty, disorder, errors, stressors…” And as the mother of a highly energetic two-year old boy, I can readily relate to the risks of fragility! But Taleb’s book isn’t about resiliency or robustness – he goes one step further: “the resilient resists shocks and stays the same; the antifragile gets better…Some things benefit from shocks; they thrive and grow when exposed to volatility, randomness, disorder, and stressors and love adventure, risk, and uncertainty”.

As I delved deeper into the book, I recalled the analogy I came up with over a year ago to try to visually portray how the Social Revolution will fundamentally alter companies’ underlying risk and growth profiles:

The social revolution can be visualized as the collective power of the individual that is starting to emerge from the depths of the earth, causing massive tremors and shifts in the ecosystem of the corporate forest. This will shake up the soil of the corporate rootsystems, exposing the “shell” companies that have a shallow stakeholder root system and rip and tear at their thin, narrow, and fragmented roots, making them more vulnerable to external risks and stunting their future growth.

Report_002-Nov2011“Heart and soul” companies, which have deep, thick, wide, and highly intertwined root systems, will be able to withstand the tremors. And they will thrive as the shaking aerates the soil and enriches the nutrients, allowing their roots to grow even thicker and spread out further. This increases their immunity to external risks, accelerating their growth as they grow new branches and become more leafy and fruitful than anyone expected. And as the “shell” companies quickly succumb to disease and natural disaster, the “heart and soul” companies will thrive even further as the nutrients in the soil are enriched, they have more space to extend their roots, and they receive more sunlight. – “Social Capital: A New Strategic Play for Investors – Look for Companies with Heart and Soul”, November 2011

As Taleb remarks, unlike black swan events, which are unpredictable by nature, “you can state with a lot more confidence that an object or a structure is more fragile than another should a certain event happen.” And the event that I describe above is the Social Revolution which I believe will shake up the soil of the corporate root system, ripping and tearing at the thin, narrow, and fragmented stakeholder roots of the “fragile” shell companies while increasing the immunity and accelerating the growth of the deep, thick, wide, and highly intertwined stakeholder root systems of the “antifragile” heart and soul companies.

As the world becomes more transparent and connected, the truth about how companies treat their various stakeholders (whether it be their employees, customers, business partners, communities, or the environment) will be exposed. This will create a high level of fragility for companies who derive their competitive advantage through exploiting their stakeholders as for the first time ever, the exploited have a voice and are empowered to join together and fight back. This will result in the fragile companies having a much higher risk profile and lower than anticipated future growth profile which from a discounted cash flow perspective, will lead to a double negative multiplier effect, leading to accelerated erosion in value. On the positive side, this will create a high level of antifragility for companies with heart and soul that have built up strong relationships and have established a high level of trust with their stakeholders. As Taleb states “word of mouth is a potent naturalistic filter. Actually, the only filter.” These antifragile companies will have a much lower than assumed risk profile and higher than anticipated further growth profile which from a discounted cash flow perspective, will lead to a double positive multiplier effect, leading to accelerated creation in value.

I am still baffled about how little attention the investment community gives to soft qualitative factors such as a company’s culture, core values, and its relationships with its stakeholders. I just returned from a three-day Institutional Investor Conference sponsored by a major brokerage firm. After a three-year hiatus from the Street, it was another wake-up call to me about how it is just all about the hard cold numbers – as of the twenty-five plus company presentations I sat through, only two of the CEOs actually made mention of their values and their company culture. Taleb seems to be critical of this as well as he states “A corporation does not have natural ethics; it just obeys the balance sheet. The problem is that its sole mission is the satisfaction of some metric imposed by security analysts…”

As a Chartered Financial Analyst, I strongly believe that financial metrics do matter – as a company needs to earn a decent return on invested capital – but in my mind, not if it is at the expense of exploiting its customers, employees, business partners, the community, or the environment. As Taleb critiques “A (publicly listed) corporation does not feel shame. We humans are restrained by some physical, natural inhibition. A corporation does not feel pity. A corporation does not have a sense of honor—while, alas, marketing documents mention “pride.” A corporation does not have generosity. Only self-serving actions are acceptable.” He goes on to assert “Of course they will eventually self-destruct…corporations are so fragile, long-term, that they eventually collapse under the weight of the agency problem, while managers milk them for bonuses and ditch the bones to taxpayers.”

As stakeholder equity does not appear on a company’s balance sheet, investors deem the deep, thick, and highly intertwined stakeholder root systems of heart and soul companies to be redundant. It doesn’t matter to them whether a company is loved or hated by its employees, customers, or its business partners and whether it is a good steward of the community and the environment as long as it maximizes shareholder value. However, as Taleb states “Layers of redundancy are the central risk management property of natural system… Redundancy is ambiguous because it seems like a waste if nothing unusual happens. Except that something unusual happens…A system that overcompensates is necessarily in overshooting mode, building extra capacity and strength in anticipation of a worse outcome and in response to information about the possibility of a hazard. And of course such extra capacity or strength may become useful by itself, opportunistically.”

When you think about it, our newly launched Customer Value Index 200 is based on Taleb’s concept of antifragility. Whereas Social Responsible Investing is focused on reducing exposure to companies that create negative externalities, thereby creating a less fragile or resilient portfolio, our strategy is to increase exposure to companies that generate positive externalities. By screening for companies with superior competitive strength that are transparent, authentic, and engaging in terms of their core values, culture, and community, we have tried to identify those antifragile companies that will thrive and prosper as the Social Revolution shakes up the soil of the corporate root system. It’s exciting as since we launched the Customer Value Index 200 on November 15th, it is up 13.0% versus 11.1% for the S&P 500, an outperformance of 290 basis points, the majority due to stock selection. However, it is important to keep in mind that we are looking for our social capital investment thesis to play out over the next decade as we see a widening gap between the fragile and antifragile. As Taleb states “few realize that we are moving into the far more uneven distribution of 99/1 across many things that used to be 80/20: 99 percent of Internet traffic is attributable to less than 1 percent of sites, 99 percent of book sales come from less than 1 percent of authors…Almost everything contemporary has winner-take-all effects….”