Sunday, February 2, 2014

Heisenberg's uncertainty principle - applied to capital allocation

I was fortunate to have read Howard Marks's The most Important Thing and I was impressed by the graph he had sketched out was how well it ties into some of the basic principles of physics that we are all aware of.

It's no secret that one of the issues that investors deal with is the ability of a company to take on capital and continue to deploy them at high rates of return. Taking out the market risk and focussing only on business risk, risk could be defined as the uncertainty of the business to deploy capital at the expected rate of return.

So, this risk depends on the following ?:

- the capital at work
- the ability of the business to soak up the capital

However, things get complicated in an IPO/private placement (we're talking primary here) because of the dollop of capital that comes in, that adds to the liquidity. Think of it as a pit stop in  a Formula 1 race - discerning viewers of Formula 1 would know that there is a distinctive change in pace post a fuel stop and change of tyres.

Remember that a slackening of pace immediately after a fuel stop does not mean that there is a loss of advantage - quite the contrary, cars/teams that have the ability to time pit stops well and decide upon the right frequency for them, have an ability to pull ahead when it finally matters.

Oh wait - is'nt that what Heisenberg's uncertainty principle is all about - that the mass and the position cannot be determined at the same time (as the video shows below). Translated in a financial context, it means that balance sheet and P & L cannot be projected accurately at the same time Or, more importantly, RoE and growth rate of RoE which are the two levers that generate shareholder value cannot be measured in tandem accurately.

No wonder, that IPO's and private investments have a much higher risk attached to them. All else being equal, the investor has to understand the company's incremental RoE even as capital (fuel ?!) is pumped in.

Sort of like measuring the velocity of a car even as the car is being refuelled. Too fast, you loose fuel efficiecy and too slow, you loose momentum/speed.

There you go , another risk unravelled, at the intersection of strategy and risk allocation.