Learning to Love Binary Outcomes

Learning to Love Binary Outcomes

Around age 40, my annual checkup started including additional tests. These tests are meant to keep me healthy, but they also have the ancillary effect of stressing me out while I await the results. Do I have some disease I didn’t even know existed (well, at least until they told me about this test, anyway)? I end up spending the weekend anxiously scrolling WebMD… and whaddya know, the lab results always come back negative the following Tuesday (at least so far).

Copy of header for blog (1)This is a binary outcome — there are two possible results. Either the test comes back negative, and you’re healthy… or it comes back positive, and you’re on a whole new path. You have no insight into the likelihood that you have a particular condition outside of macro-probabilities (aka, 1 in 10,000 people have this condition, 15 in 10,000 have this other one, etc.). 

Even though the overall odds might be tiny that you have that particular condition, the ramifications if you do indeed have it are huge. The binary difference between 0 and 1 in these cases might as well be the difference between 0 and 1,000,000. And because the stakes of that 0 vs. 1 are so high if it’s a “1”, you end up obsessing over it. If you’re like me, you may even get a little sick to your stomach.

Just as uncertainty about our personal health causes nervousness bordering on nausea, uncertainty within investing can have a similar effect.

The stock market has a host of companies with mission-critical binary outcomes baked into the business model (like a small biotech firm with a big clinical trial or a startup with a pending patent case). If the clinical trial or patent succeeds, the company could add billions in market cap overnight. If they fail? It could be curtains for those companies. 

All else being equal, investors tend to avoid unnecessary uncertainty if they can help it. There aren’t a lot of investment analysts eager to stake their job on a binary outcome… feels too much like a coin flip. But that also presents a pretty huge opportunity for an investment firm who thinks about things differently. If you’re willing to weather a binary outcome environment, there’s fertile hunting ground for undervalued investments. 

Case in point: our SMID strategy owns Burford Capital, which finances legal cases for companies that either can’t or don’t want to fund the litigation expenses on their own. Burford provides the capital for the associated legal bills, and in exchange, they’ll receive a portion of any winnings should the action succeed. 

Burford is party to a big case — YPF — in which the government of Argentina is the defendant. If Burford’s action succeeds, the potential reward could be greater than the market cap of the entire company. Yes, it’s a binary outcome, and that outcome is uncertain… but we like the risk/reward.

When it comes to our health and our finances, binary outcomes can be scary. They’re stressful and uncertain, and the stakes can be quite high on one side of that particular equation. But in the right scenarios, we firmly believe they can be worth it. 

Over our lifetime, one of these medical tests will likely catch some condition early, which then gives us a far better chance of beating it. 

Within our financial portfolio, a few more unsettling Monday mornings will add some days of chaos to our schedule, sure… but they can prove worth the discomfort 10 times over if you nail one. Some of our binary investments will end up being painful; some will be tremendous. On balance, though, we think they’re likely to add to our long-term returns.


IMPORTANT DISCLOSURES

This post is for informational purposes only and should not be viewed as a recommendation to buy or sell any security or personalized investment advice. The views and opinions expressed by individuals are their own and not the views or opinions of their employer. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. No discussion or information contained herein serves as the provision of, or as a substitute for, personalized investment advice. To the extent that a reader has any questions regarding the applicability above to his/her individual situation of any specific issue discussed, he/she is encouraged to consult with the professional advisor of his/her choosing. City Different Investments is neither a law firm nor a certified public accounting firm and no portion of this content should be construed as legal, tax, or accounting advice.

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