Managing Optionality In Your Investment Portfolio

Consider the balance between resilience and optionality. Resilience is what most traditional wealth management firms focus on, and for good reason. A commitment to investment resilience means owning foundational ‘always there for you when you need it’ investments. Examples include cash, fixed income, many types of real estate, social security, pensions, stable salaries and core equity holdings. However, don’t forget that at the right times and in the right amounts, committing to investments with optionality can produce incredible outsized returns. Often, the most successful investors are capable of doing both: building their resilient investment foundation while allocating a portion to long term, high risk and high potential investments. This article will focus on the latter, the optionality and the long term opportunities.

A fast-changing world

It’s fair to ask: Why bother with high-risk high-growth businesses when you can earn resilient returns via mix of the core S&P 500 type equities and core traditional bonds? The evidence confirms what we’ve suspected (known) for many years; we are living life at a faster pace than ever before. The coronavirus of 2020 has accelerated this pace. Much of the world is still analog and the transition from analog to digital will continue to produce substantial gains and substantial losses across all industries. Consider that as the world continues to change, many of today’s most resilient businesses may not be able to keep up. Analog will eventually fade and the digital will, over time, dominate.

This divergence between future winners and losers was evident in March of this year when the gap between value and growth widened substantially. Growth is more often digital and value is more often analog. It just so happens that the majority of technology and innovation forward businesses fit into the growth category. Unlike 1999, a new class of digital defensives has emerged- scale and high margin software and hardware businesses that have grown at multiples of GDP growth rates. Execution has been steady, and these businesses have invested to remove competitive threats.

An often-cited example of the damage done by disruption is the once-great Kodak company that was replaced by digitization and the invention of the iPhone (However, oddly, Kodak is making a peculiar comeback this week as a drug company). Soon Tesla may replace Exxon as the key dominant energy player in the US. Despite the perception of safety and resilience, holders of Exxon have lost substantial value year after year. Exxon last peaked in 2014. The world shows no signs of slowing down, and disruption is on every executive’s mind as they guide their business forward. Investing with optionality in mind allows you to keep up with that pace of change so that you don’t risk falling behind.

It’s always a good time to invest in the future

Optionality provides an antidote to a fast-changing world. This rapid period of innovation is why I say that it’s always a good time to invest in the future. Google’s Waymo may be the next dominant player in self-driving technology, and that will be great for their stock price if they achieve that lofty goal.

DocuSign helps real estate agents with speed, flexibility and efficiency. Twilio provides amazingly inexpensive and scalable telecommunications APIs that today’s innovators can play with to eventually create new businesses and new opportunities. Livongo helps doctors and specialists monitor chronic illnesses in real-time (and 40% of Americans have a chronic disease). These companies are just a few examples of new innovative high growth businesses with optionality built-in. If these businesses win, they will win big. If they lose or stall, the dominant player in their industry will probably acquire them. A company’s end by acquisition is natural and conventional. There seems to be no end to the digital revolution as we continue to explore opportunities in AI and the effects of connecting 5 billion people on a single network.

Slack, for example, has been a mostly unsuccessful IPO to date. The bear case for Slack is probably not a significant loss of value. Instead, the bear case probably looks more like: they get sold to Amazon for a 50% loss relative to their IPO. That’s not a terrible outcome considering businesses like Slack can double, triple and even 10x when things go right.

Optionality has existed in public markets for decades and continues today. When investing for optionality, it’s essential to let your winners keep on winning for many years, if not decades. Long term holders of Apple stock know this. What was once a $50,000 position in Apple 10 years ago is now a $500,000 position. Allocating to growth opportunities is not as hard as picking the next Apple. There are many examples of major public companies that have experienced a 10x return over the past ten years. They have similar properties, and it’s not by any means impossible to find them.

Avoid gambling and avoid “priced to perfection.”

Gambling: Be careful not to give too much credence to companies that overpromise. There are many companies today that have only an operating plan and no revenue, yet they trade like established businesses. Nikola, the future electric truck business, is like this. Nikola’s range of possible outcomes from very good to very bad is too extreme, in my opinion. In a world of thousands of investment choices, there are surely options out there with a more predictable range of outcomes.

Priced to perfection: Sometimes, a valuation gets so high that future fundamentals must continue to be nothing short of perfect. We call this priced to perfection. Shopify was starting to look like this since it started trading at 50x EV/Sales a few weeks ago. At this valuation, they must vastly exceed earnings expectations each quarter, which they did in spectacular fashion yesterday. Just be aware when valuations are too high or when fundamentals become “priced to perfection.” What is too high for Shopify? 100x EV/Sales? Probably. There is a limit.

Striking the right balance

Everyone wants to know the answer to the question, “so what’s the right allocation for me?”. Invest too much into optionality, and you risk blowing up a meaningful portion of your wealth. Remember that innovative companies can be at high risk of economic disappointment. You want enough allocated to optionality to produce significant growth, but not so much that you introduce unnecessary anxiety and stress into your life.

My suggestion, and how we answer this question for clients, is to review your lifetime flow of expenses and compare that to the resilient part of your portfolio. As long as you cover your essential, important and discretionary expenditures in perpetuity, then you have room to invest in high growth high-risk opportunities where the risk of ruin has little to no impact on your life. The answer is highly dependent on personal circumstances and your financial priorities.