The world is in period of uncertainty which seems to be the only thing people are certain of. Ever since BREXIT and the Trump election markets have performed differently than expectations. This unexpected reaction has lead me to begin thinking about what could the biggest white swan (a positive unexpected event that is not priced in) that could happen over the next four years as well as how to profit.
The term black swan originated from a Dutch explorer in Australia. I found this synopsis on the internet:
“The term Black Swan originates from the (Western) belief that all swans are white because these were the only ones accounted for. However, in 1697 the Dutch explorer Willem de Vlamingh discovered black swans in Australia. This was an unexpected event in (scientific) history and profoundly changed zoology. After the black swan were discovered, it seemed obvious that black swans had to exist just as other animals with varying colors were known to exist as well. In retrospect, the surrounding context (i.e., the observations about other animals) seemed to imply the Black Swan assumption – empirical evidence validated it.”
The term made its journey to the financial world in Nassim Taleb’s excellent book The Black Swan: The Impact of the Highly Improbable. In the book Taleb tells a parable about a turkey’s life and explains that Thanksgiving and the harvesting of turkeys is a black swan for the turkey but not the farmer. His solution and advice is to “avoid being the turkey” and through analysis an investor can build a robust and antifragile system that attempts to “turn the Black Swans white“.
So what is the biggest white swan I can imagine?
Quite simply, the destruction of ISIS through an American and Russian coordinated counter terrorism operation. I think this has not been priced into any market. This leads to the next question, how to profit?
To determine the answer to this second question I required some parameters.
- it has to be investable
- the investment has to have high optionality – an extreme high payout when the events get priced in
- the downside has to be protected to a certain degree
- it cannot have a shelf date or limited time span
- it cannot be a fraud
- I require leverage and be able to win large on a small bet.
To fit criteria #1, #4 and criteria #5 I believe that common stock in a company listed in a jurisdiction where I trust the regulatory environment is the correct instrument.
To fit criteria #2 and #3 it has to have positive skew (small frequent losses but large infrequent gains – see below chart). This requires the company to be a going concern regardless of whether ISIS is defeated, but where the valuation changes drastically to the upside should ISIS be defeated.
To satisfy criteria #6 this company has to be priced cheaply.
In trying to satisfy all these criterion I believe the solution is to invest in small oil and gas companies with current production, exploration upside, a balance sheet that can sustain current operations while executing expansion plans (regardless of whether ISIS and the difficult financing enviornment continues), have their operations in Kurdistan and be listed in Canada, the US or London.
There are very few companies that fit this description and I will let the reader create a list of their own names. Should Kurdistan become free of ISIS interference the political risk of the area and the companies involved would be reduced and the population of investors that would be willing to risk capital in this region and its very favourable geology will expand. As cash flows towards these speculative investments and the discount rate used to value the assets is reduced an increase in the valuation should change the share price to the upside.
This is not the type of idea that one goes “all in” on. A small allocation of capital is the correct way to approach this strategy with the expectation that there could be frequent small losses with the potential for an infrequent large profit. This what I will refer to as my white swan lottery ticket strategy.