Until it Happens...

Taking the barbell approach to early stage ventures

Note: all underlined words contain a hyperlink that links you to the topic in more detail.

The Barbell Strategy was briefly mentioned in the previous article (Be an Octopus), but I wanted to expound on the concept a little bit more since I see tremendous value in this approach.

Before I discuss this approach, I think it makes sense to give a little background on Nassim Taleb and his fund Empirica Capital (which eventually evolved into Universa Investments and is now run by his protégé, Mark Spitznagel). Taleb founded Empirica in 1999 with the premise that humans are wildly irrational, emotional, and short-term in nature. He considered this a fact and part of our DNA (based on evolution), and he studied this deeply before starting the fund. With this thesis, he decided to invest his own money and eventually partnered with Spitznagel to take advantage of the irrationality of humans.

The whole idea behind their thesis is that during times of stability and uptrends in the market, there is a strong consensus among the irrational population. Hence, consensus can breed instability. If you are the type who believes that we are rational beings and that the news is always correct, or if you believe every word that comes out of one political camp just because you are either Republican or Democrat without objectively understanding the underlying problem, then you probably won’t agree to this. One might ask 'well, that’s what everyone does, so why am I wrong?' The whole point of this philosophy is that the average person is irrational. So, if you are average, you are irrational. And being average means doing what everyone else does or believes.

There is one important catch here: instability doesn’t happen gradually, it happens immediately and instantly. People don’t know they are breeding instability.

Until it happens…

This, in a nutshell, is what Universa believes in and invests based on this thesis. By the way, Taleb didn’t just say this about the general population, the middle class, or those with no college degrees. He said this about the entire Wall Street. He truly believes that we humans have strong tendencies (biases) rooted in our biological history that are hardwired within us, and a few recognize them and make a concerted effort to address them. This is where Munger and Taleb align (even though they never collaborated), and you will see it in Munger’s 'Psychology of Human Misjudgment,' which was mentioned in a previous article. Coincidentally, both Taleb and Munger believe in the irrationality of crowds but take very different paths to generate outsized returns.

Here is an example of Buffett and Munger talking to a crowd about humans and casinos:

We all watch the same shows, the same news, and follow the same trends. During times of euphoria, it becomes hard for humans to recognize that they are following a trend or to acknowledge that they might be on an irrational path. It is difficult to move away from consensus and disagree with your neighbors. This doesn’t happen just in investing; it occurs in all aspects of our lives. However, the irrationality in what we call ‘life’ is usually reflected in the financial markets in the form of ‘booms and busts.’ This is why the best investors study human psychology and philosophy. Number crunching is just a tiny aspect of this game and is almost commoditized as a core skill.

Now, going back to Taleb. We have this guy who recognizes the irrationality of crowds and asks himself how he can take advantage of this ‘truth’. Long story short, he bets against the crowd. How? He takes advantage of what’s called ‘out of the money options’. As a layman, if you google call and put options, you might go cross-eyed with the formulas, but there is a simple explanation to how they work. An option is the right, but not an obligation, to sell or buy something. How do you obtain this ‘right’? You pay for it, and depending on what the underlying asset is and how it performs, every right has a different price.

Let’s give some examples:

Let’s say you truly believe that NVIDIA’s stock will continue to rise over the long run, and you have a strong conviction that this is the case. Instead of buying the stock outright, you can purchase what’s called a call option, which gives you the right, but not the obligation, to buy the stock at a FIXED price. So, if the fixed price is $880, and it eventually reaches $1000 before your option expires, you can buy the stock at $880 and sell at $1000, making a spread (profit) of $120.

You can buy call options that expire in weeks, months, and even years. The catch here is that it comes with a price. You don’t just get these options for free; you pay someone else what’s called a ‘premium’ for you to have this right to buy. The more likely something is to happen (in the views of the general population), the more expensive the option, and the higher the premium. Given all the talk about AI (I think it is fair to say this is consensus speaking), the near-term call options for NVIDIA are probably on the expensive side.

Let’s use another example. Let’s say someone (let’s call him Joe) believes that aliens will invade Earth, and everyone else thinks Joe is nuts. What Joe can do is envision a world where aliens control every aspect of humanity, and he can invest in things that reflect this new reality. Instead of investing in that reality now, he can buy the option to do so just in case it doesn’t happen. How much would it cost him to have the option to invest in this new alien world order? Probably next to nothing. Why? Because consensus believes that it will never happen and will be willing to sell him payouts that will never materialize. In their eyes, it’s a free lunch from Joe in the form of small premiums.

Until it happens…

If for some strange reason aliens do invade Earth, Joe will make a fortune. What is his downside? A tiny premium that gave him the right to get into this setup. It was probably so tiny that even if aliens didn’t invade this planet, it wouldn’t have put a dent on Joe’s wallet.

Think of it like insurance. If you approach an insurance company and pay a premium to insure against alien attacks, they would gladly provide it at a low price (premium). The only thing is that they don’t have products for it, but I am sure a product can be made if there is demand for it. Where there is demand, there is supply (i.e. Wall Street).

What Taleb does with Universa is similar to what Joe does. He invests in out-of-the-money options on events that are unlikely to happen, while everyone else downplays the likelihood of them happening.

Until they happen…

Another example is that of Dr. Michael Burry from The Big Short when he made a bet on out-of-the-money credit default swaps:

People thought he was crazy and stupid.

Until it happened…

Without getting into too much detail, this approach has generated enormous amounts for Universa and its shareholders, and they continue to apply this strategy to this day. They take positions in options that pay out during ‘alien-like events’.

Universa and Empirica followed the Black swan theory which was about unexpected extreme events that have significant impact on the world and the financial markets. The strategy would be to buy out-of-the-money put options at low prices during periods the financial markets are good to protect the firm's position when there is a market downturn. Universa purchased puts related to the S&P 500 Index and financial companies such as Goldman Sachs and American International Group which the firm sold for a significant profit after the prices fell.

In 2008, Universa had returns over 100% and its assets grew to $6 billion under management in 2009 as more investors approached Universa to provide protection to their investments.

During the 2015–2016 stock market selloff, Universa had a return on 20% in August 2015 which resulted in a $1 billion gain.

In March 2020, Universa, in a letter to investors, estimated it had a return of 3,612% on invested capital in its strategy due to effects caused by the COVID-19 pandemic.

In 2018, The Wall Street Journal reported that "a strategy consisting of just a 3.3% position in Universa with the rest invested passively in the S&P 500 index had a compound annual return of 12.3% in the 10 years through February (2018), far better than the S&P 500 itself" (and portfolios with "more traditional hedges").

Wikipedia

This is an impressive return.

There is a catch to all this, and it isn’t all free for anyone to get into. What’s the catch? You must lose a little during good times (the costs of options), while the irrational folks go the other way. It's not an easy thing to do when everyone around you is singing Kumbaya to rosy trends. Like Michael Burry in that video, you become an outcast, and your relatives, friends, and even people you admire might be against you.

The interesting thing is that this strategy is free to learn and anyone can find material on it online. Yet people don’t follow it. People ask 'If they do it, why can’t other people follow?' The answer is not in the genius behind the numbers and the formulas, but in a person’s temperament. It’s like learning to be patient, healthy, hardworking, etc. These things don’t just happen overnight; it takes years of proper upbringing with a unique history. In short, having temperament is a virtue, and it cannot be learned overnight. One that emphasizes self-control, rationality, and resilience, and at times, being able to accept being in an inferior position for the ‘truth,’ is what makes a good investor.

Let’s go back to Taleb and The Barbell Strategy. The Barbell Strategy is essentially an investment model that allows anyone to invest like Universa. It goes like this:

Here is a detailed video of Taleb explaining how he does it:

Essentially, this is a model where you invest 85% of your cash into assets that are generally safe (think high-grade bonds, real estate, and even leaving some as cash). These are assets that yield boring returns during both good and bad times, but they never lose money. The remaining 15% goes towards assets that are extremely risky but offer extreme payouts if you get it right. This is the world of venture capital, early-stage tech ventures or… alien-like events.

I bring this up because right now, I see a one-size-fits-all model when it comes to early-stage investing. You have the venture capital firms who “spray and pray,” hoping that 1 out of 100 of their investments returns 10x its entire portfolio. This model works and has proven to work for a handful of investors, but it can derail funds during prolonged downturns, especially when the timing exceeds a fund's life. We have seen this happen in the dot-com bubble and again today (post-COVID). When you look at the typical VC model, the main assumption is that 90% of startups fail, and so managers accept extreme losses with the understanding that a few winners can bring extreme gains. It looks like the following:

Some might say that the extreme returns compensate for the extreme risks over a fund's life, but markets don’t always behave as if gains happen within a 7 or 10-year window. In fact, most of the time gains never materialize at all (though a handful have a record of success). If investors time it right, they might catch an upswing, but if they don’t, they’ll be left with lingering companies for a period of time. Since VCs have a fixed fund life, they don’t have the flexibility to wait.

I prefer an approach that incorporates some aspects of the barbell strategy, where one can invest in a number of stable early-stage companies, such as innovative cash generators as explained in my previous article 'Brick by Brick.' These are early-stage companies that have determinable cash flows where upside is strong (but not extreme), and enough to earn multiples on your money with a lower risk of extreme loss (although I would argue that there are still extreme gains to be made, but that is for another discussion). This is the world of brick-and-mortars. This would consist of 85% of the entire portfolio, while 15% would consist of contrarian illiquid positions with more uncertain payoffs, but ones with extreme rewards if done right. The payouts look more like the following:

I call this the barbell venture approach. It’s about creating a portfolio of stable companies and holding them long term, while investing a small amount in highly risky (illiquid) bets that on their own won’t be big enough to significantly impact the portfolio if things go sour. In aggregate, you will have a portfolio that will probably look boring, but over time will realize some ‘pops’ that hopefully bring outsized returns and extreme wealth.

The majority of this portfolio will align with the model of Justin Ishbia:

We have a lot to learn from Nassim Taleb and his team at Universa, and knowing the right positions is only half the battle. Understanding your own human nature is the bigger obstacle, but if effort is made, you can expect to achieve returns that far exceed the crowd.

If you are interested in the psychology of human behavior and how it impacts markets, I highly recommend the following books by Nassim Taleb and his protégé Mark Spitznagel:

ABOUT THE AUTHOR

Keenan Ugarte is Managing Partner at DayOne Capital Ventures, an independent private holding company based in the Philippines that partners with entrepreneurs across a wide range of industries. He is the Co-Founder and Director of The Independent Investor.