How to build an Antifragile Portfolio

Mar 05, 2023

In my previous post, I explained about the concept of fragility using flower vase (fragile) and rubber ball (robust) as examples.However, robust is not the opposite of fragile. N N Taleb explains in his book that a fragile item breaks with stress and a robust item does not easily break with stress. However there are few objects which gain from stress. As there is no word in English language to describe such objects, Taleb coined the word Antifragile to represent such objects which gain from stress/disorder.

Raktabija is a Asura in Hindu Mythology. He acquired a boon from Shiva that whenever a drop of his blood fell on the ground, various Raktabījas would emerge from the spot, equivalent to his strength, form, and weapons. Raktabija can be considered as Antifragile due to this boon,

We can use this concept to categorize various businesses into Fragile, Robust and Antifragile. However, categorizing a business into these three categories is not a straightforward task, as there is no universally accepted definition or metric for it. One approach we can use is:

Based on optionality:

This approach proposes to measure antifragility by using the concept of optionality, which is the ability to choose among different alternatives in an uncertain situation. A system is antifragile if it has more options than obligations, fragile if it has more obligations than options, and robust if it has equal options and obligations.

Optionality can be estimated by factors such as cash flow, liquidity, leverage, diversification and growth opportunities. These factors show how well a business manages its risks and capitalizes on its opportunities.

Fragile Business:

A fragile business has more obligations than options. An example of a fragile business is an Airline business.

There is very limited flexibility in pricing an airline ticket due to intense competition in the sector. If a company tries to price its tickets slightly higher, then there is a risk that the flight might have to take off empty. There is also limited flexibility when it comes to expenses. The company has to take off the flight even if very few passengers booked tickets. Hence, majority of the expenses of the company like Fuel, employees, parking charges, etc are fixed irrespective of whether there are passengers or not. As setting up an airline is a costly affair, company will likely have to resort to external sources of capital like Debt for funding which further reduces its financial flexibility. An airline business is also highly regulated. Hence, based on optionality, an airline business is a fragile business.It is not surprising that a lot of Airlines in India failed despite the overall growth in the sector.

Robust Business:

Colgate -Palmolive (India) Ltd can be considered a Robust business as it is in the business of selling Toothpaste. People wont stop brushing their teeth whether there is a financial crisis or during COVID or during demonetisation.Its revenue is robust. At the same time as the market is saturated wherein it is present in the entire addressable market, there is little scope for growth in revenue apart from premiumisation of toothpaste. While Colgate’s obligations are limited (Zero Debt and nil expansion cost), its options for growth are also limited. That is also the reason why it paid majority of its cash flows as a dividend. Against cash flow from operations of Rs 5017 Crs in the last five years, it paid dividends of Rs 3654 Crs.

Antifragile business:

A business which has very few obligations and multiple options is an antifragile business.Some characteristics of antifragile businesses are:

The business has a strong brand or proprietary technology that gives it a competitive edge and allows it to adapt to changing customer needs and preferences.
The business has a diverse portfolio of products, services, markets and customers that reduces its dependence on any single source of revenue or demand.
The business has a culture of innovation and experimentation that encourages learning from failures and mistakes and fosters continuous improvement and creativity.
The business has a flexible and agile organizational structure that enables fast decision making and execution and empowers employees to take initiative and responsibility.
The business has a high degree of optionality that allows it to exploit opportunities and avoid risks by having multiple choices and alternatives available at any given time.

These are some characteristics of antifragile businesses that help them thrive in uncertainty and change.

It is very rare to identify an antifragile business with all the above qualities. Few examples are:

Insurance: Insurance coverage increases immediately after a crisis. Further, an insurance company takes premium in advance and is required to compensate if any at a later date. During this interim period, it can invest this money in various assets and thereby earn income. An insurance company is also scalable as it can increase its revenue through online/offline modes without incurring major expansion costs. This makes the business model of an insurance company antifragile as it has very limited obligations and multiple options for expansion..

Reliance Industries: The company used its cash flows from its robust Oil business to setup Jio and Reliance Retail. These new businesses turned out to be market leaders in their respective segments. The company converted itself from Robust business into an Antifragile business.

Scalability as an alternative

While it is difficult to identify an Antifragile business, we can instead easily identify scalable businesses. Scalability means the ability of a system to handle increasing amounts of work or demand without compromising performance or quality. Scalable systems can grow in size and complexity without losing efficiency or functionality.

Therefore, scalability can be one of the factors that contribute to antifragility, but it is not sufficient by itself. A business can be scalable but still fragile if it cannot adapt to changing environments or customer needs.

New industries like Electric vehicles can be considered scalable as there is a long runway for growth. Sometimes even in old industries, we can identify companies with long runway for growth due to premiumisation of the product. .For example luxury cars or SUV segments in India. With increase in disposable incomes, the demand for these cars is increasing faster than the entire segment. Online businesses can also be considered as scalable.

A scalable business can also be fragile as the sales can fall abruptly with disruption. Facebook blames Apple after a historically bad quarter, saying iPhone privacy changes will cost it $10 billion.

Netflix used to boast that its biggest competitor is sleep. However, it recently declared that Netflix password sharing is costing the company billions.

While a scalable business has features of antifragility, it also has some features of fragility. Hence scalability is not a fool proof method for antifragility.

Antifragile Portfolio Strategy

One strategy proposed by N N Taleb is using the barbell strategy. A barbell strategy is an investment approach that involves allocating a large portion of funds (such as 80-90%) to safe and stable assets and a small portion of funds (such as 10-20%) to risky and volatile assets.

The idea behind this strategy is to protect the portfolio from negative black swan events (unexpected and extreme events that have a large negative impact) while exposing it to positive black swan events (unexpected and extreme events that have a large positive impact). The safe assets provide a buffer against losses and preserve capital, while the risky assets provide a chance for high returns and growth.

The barbell strategy also aims to exploit the nonlinearity of returns, meaning that some assets have more upside potential than downside risk. For example, an option contract might lose its entire value if it expires out of the money, but it might increase exponentially if it expires in the money. Similarly, a start-up company might go bankrupt or be acquired for a huge premium.

The barbell strategy can be seen as an antifragile approach because it benefits from uncertainty and volatility rather than suffering from them. It also avoids the middle ground of moderately risky assets that offer neither safety nor opportunity. By diversifying across two extremes, the barbell strategy can achieve better risk-adjusted returns than a conventional portfolio.

We can use this strategy by building a portfolio with a mix of Robust businesses (80 to 90% allocation) and a small portion of funds (such as 10-20%) to highly scalable businesses.

One precaution we need to take for building a robust businesses portfolio (80 to 90% allocation) is that our entry valuation should not be overvalued, as overvaluation introduces fragility.

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