BUTTERFLIES AND SHRIMP

In the 1960’s, a meteorologist by the name of Edward Lorenz posited that tiny “butterfly-size” changes to the starting point of his models could result in anything from sunny skies to violent storms. This was problematic because if true, it meant it was nearly impossible to make long-term weather forecasts. 

This phenomenon, commonly referred to as the “butterfly effect”, implies that a seemingly innocuous event (such as a butterfly flapping its wings) has the potential to completely upend a complex system. In Lorenz’s case sixty years ago, the butterfly was a small change in the weather. In investors’ case more recently, it was Covid. When the first transmission took place three years ago, be it in a lab or a wet market, it set into motion a series of “storms” that have disrupted the global economy in once unimaginable ways. 

Recently, these storms have included generational inflation, a collapse in high growth stocks, material political and geopolitical strife, tighter monetary policy, the collapse of Web 3.0 and crypto, and most recently, the Silicon Valley Bank and Credit Suisse bankruptcies. Unfortunately, these storms appear to be far from over. In fact, if you look off the coast, you can see the next ones approaching in the form of commercial office market distress and in the banks that have financed it. Even more concerning though are the storms that are too far offshore to see quite yet. 

Most people want to know who is most vulnerable during these storms, which is understandable given that fear is the primary emotion during periods like this. However, the more interesting question for investors is who stands to benefit the most once these storms pass? 

As I thought about this question over the weekend, an odd image kept coming to mind — Forrest Gump. More specifically, Bubba Gump Shrimp. 

I know what you are thinking. What does the 1994 Oscar-winning film starring Tom Hanks have to do with economic distress, a potential recession, and falling markets? On the surface not a lot, but keep reading and I think you will see the connection.

About half way through the movie, Forrest Gump returns from fighting in Vietnam. To honor a commitment he made to his best friend Bubba, who died in his arms during a firefight, Forrest buys a shrimping boat in Bubba’s hometown of Bayou LaBatre, Alabama. He of course names the boat “Jenny” and sets out to sea to catch some shrimp. 

Initially, Forrest is an utter failure as a shrimping boat captain. Time and time again, the only thing his nets pull up are shells and empty beer cans. While Forrest’s lack of experience is certainly part of the problem, it is not the only factor at play. The fact is he is up against a lot of competition. There are simply too many shrimping boats and experienced captains roaming the Alabama coastline. That is until something happened that changed the entire equation. 

Just when Forrest appears to be at the brink of failure, a massive storm hits the Gulf Coast. Given Forrest was out to sea shrimping when the storm hit, the “Jenny” survived. However, the vast majority of his competition was not so lucky as every boat docked ashore was destroyed. By simply surviving the storm, Gump and the “Jenny” end up with a virtual monopoly. The result? Endless shrimp and profits, which led to the creation of the Bubba Gump Shrimp Company. 

Forrest Gump is obviously a work of fiction, but the lesson holds. Success in business and investing is pretty simple when you boil it down — it largely depends on your ability to weather storms and then take advantage of a less competitive environment once they have cleared.

In a recent podcast, Morgan Housel highlights the first part of this dynamic. In his words, the key to weathering storms comes down to making yourself financially “unbreakable”. 

But, how does one become “unbreakable”? 

Housel argues through a simple action — by keeping more cash on hand. 

“Holding more cash often leads to the biggest investment returns because it is what enables you to stick around. Sure, earning nothing can gnaw at you during a bull market if it earns 1% while stocks go up 9% annually. Yet, if that cash prevents you from selling your stocks in a bear market, the actual return on cash is not 1%, but rather much higher because preventing one desperate mistake can do more for lifetime returns than picking dozens of big time winners.” 

If Housel is right, investors collectively might be making a major mistake. Instead of focusing a disproportionate amount of time on finding the next great stock or fund, maybe they should focus more time on simply preventing compounding from being interrupted. 

The first step? Do not run out of cash. 

Unfortunately, my guess is that over the next few months and quarters, we will see a lot of young tech companies, real estate owners, and potentially banks run out of cash as the bill comes due for relying on cheap debt or new external sources of cash for too long. In fact, we are already seeing investors in these assets who entered this downturn running light on cash not have enough left to redeploy into public markets or make new commitments to the private markets. This is likely to continue for the foreseeable future. 

There is a logical follow up question to this though — who stands to benefit? Unsurprisingly, those who entered this period more conservatively positioned. By making themselves “unbreakable”, these investors and companies have put themselves in a position to purchase distressed assets at discounted prices and/or grab more market share when calmer seas arrive. 

Looking Ahead

Every crisis does the same thing — they destroy demand, which in turn reduces the supply of competitors. While this is a devastating reality for those who do not make it to the other side, it often leads to immense profits for those that do when demand eventually returns. This is precisely why being financially unbreakable matters so much. 

The interesting thing is that in most cases, you do not even need to be overly talented to be successful in these less competitive environments. Just look at commercial real estate investors following the S&L crisis, tech investors following the dot.com bust, homebuilders following the financial crisis, energy producers in the wake of the most recent bust, or Forrest Gump in the wake of the storm. In each case, talent mattered a lot less than simply being able to “show up”. Afterall, almost anyone can make money buying buildings for cents on the dollar, scooping up tech companies down 90+%, building homes in the midst of a massive home shortage, drilling wells when oil prices are high, or catching shrimp when you are the only one doing it. 

John Kennedy once said, “The time to fix the roof is when the sun is shining.” Unfortunately for many investors today, the sun is currently well behind the clouds, especially for those who were over-allocated to assets that have already fallen a considerable amount. As a result, raising cash is no longer a viable option. However, for those who made themselves unbreakable by carrying more cash and/or being more conservatively positioned, the next few quarters and years will likely be a generational buying opportunity. 

Now, what about those investors who may have exposure to assets susceptible to storms on the horizon? 

This is precisely the time to confirm that you and your portfolio are durable enough to get to the other side. The tricky thing is, there is no “right” answer, solution, or specific level of cash needed to be “unbreakable”. Instead, it is a highly personal decision. For some, this might mean holding a modest amount of cash and a few defensive assets. For others, this might mean carrying a significant amount of both. Either way, the important thing is to determine what that amount is. It sounds easy, but it is arguably the hardest and most important decision any investor will make. 

And in Forrest’s words, “that’s all I have to say about that.”