One of the most useful frameworks I learned in law school was what I call the “Run it Out to the End” framework. The mental exercise of following an idea to a logical conclusion isn’t complicated, but it seems to be done less and less by our attention strained society. It seems there just isn’t time to think anymore.
Everything we read is headline / clickbait driven and most people don’t take the time to understand a topic, or a stock, or an investment scenario, and “Run it Out to the End”.
In order to run something out to the end you need an ability to think clearly and with an open mind, even when it goes against the majority, or “expert” opinion, or what the “people in charge” are saying.
We’re really talking about applying common sense to a situation when everyone else is running around with their hair on fire. If you liked Geometry in school (which I did, remember doing proofs? that was fun stuff, no really, no sarcasm there), I’m talking about deductive reasoning.
It’s using simple exercises like the “If, Then” statement. Eg., IF Apple (AAPL) tried to sell $1,000 iPhones to people making $10,000 a year or less (China and India), THEN they probably won’t sell as many iPhones.
Now, don’t get me wrong. I’m not saying this easy stuff (though sometimes it is). It takes practice and in some cases some expertise that you, and I, may or may not have. In those cases you can 1. Learn, and become enough of an expert to tackle the problem, or 2. Move on to another stock, or problem.
Let’s look at a few case studies to make this more concrete.
“Run It Out” Case Studies
Soros Breaks the Bank of England
One of the most famous financial instances of “Running it Out to the End” was George Soros breaking the Bank of England. There has been a ton written on this, so I’m not going to rehash the whole thing here. You can get the story here, here, or here.
Soros didn’t actually “break” the British pound, but he understood the market forces that were at work, and hypothesized that the market would break the pound. He simply bet that the government of England could not go against those forces for very long.
Think of it this way. If I ran a book store and I priced all of my books at $100 each, I’d be out of business pretty fast. Books generally sell in the $.99 (for a kindle version) to the $35 range, for a nice color printed cookbook. So if you could short my bookstore stock it would probably be a good trade.
That’s what Soros did. He had an understanding of the currency markets, and saw weakness in all the other currencies. When the Bank of England declared they would keep the pound strong, Soros thought they couldn’t. This was especially true when they linked their currency to the weaker German mark.
Basically, they couldn’t sell $100 books when everyone else was selling $25 books. Something had to give.
Now, the question I would ask is, why didn’t every other currency trader see the same thing and short the pound as well (some did btw). They didn’t see it because they listened to “the people in charge”, the Bank of England. The Bank declared they would keep the pound strong, so traders took them at their word.
Admittedly there were a lot of moving parts to this story, but Soros put the pieces together and simply ran out the scenario to the end. He bet the market would be stronger than the Bank of England and won a billion dollars.
Space, the Final Frontier
If you’ve paid any attention to the news lately you’ve seen a story or two about Virgin Galactic and Richard Branson’s endeavor to take people to space. He’s getting very close to accomplishing his goal, and plans to launch the first commercial flight in 2019.
As it happens, I once worked for a very large consulting firm, and ping-ponged between consulting for financial services companies and government agencies (Prudential, NYSE, FDIC) , and aerospace and defense companies and organizations (Raytheon, NASA, U.S. Navy).
As part of this job, I had the opportunity to work on a team performing a due diligence look at Scaled Composites. Scaled Composites builds the spacecraft for Branson’s Virgin Galactic, and at the time had won the Ansari X Prize for being the first non-government enterprise to send a man to space.
I was in charge of looking at the engineering department at Scaled Composites. Then, and we’re going to get really technical here, the company’s main revenue came from building aircraft that could fly really high or really fast (the technical terms).
They would then rent out space on these aircraft, to companies like Northrop Grumman (NOC) and Boeing (BA), to test instruments that could only be tested under real world conditions in aircraft like those built by Scaled Composites. They actually had a backlog of customers waiting to test stuff. Not a bad business model.
Over the years Northrop Grumman had become an investor in Scaled Composites and at that time owned 40% of the business. The remainder of the company was now up for sale, and we were performing the due diligence on behalf of a private equity firm.
As part of its ownership deal with Scaled Composites, Northrop Grumman also had a right of first refusal to buy the remainder of Scaled Composites if it came up for sale.
Two sentences on defense firms. Defense as a business is cyclical. But, if we are not in a down part of the cycle (and sometimes if we are), defense firms are always looking to pick up companies with the newest shiny gadget, or that fit even tangentially into their business.
Leadership is often former military, makes sense. And they like to gather resources for when they might need them, also makes sense.
In the course of the due diligence it became apparent that Scaled Composites was pretty impressive. They were doing cutting edge aerospace engineering, developing cutting edge aircraft, and doing just fine financially.
After this became apparent, I told our team project manager one day, that I believed Northrop Grumman was going to buy the other 60% of Scaled Composites they didn’t already own. The project manager was a REALLY smart dude, a physicist, great with detail, and I highly respected his opinion.
That’s why I was surprised by his response to my big picture deductive reasoning. “No way,” was his very assertive answer. Why would they have us in doing the due diligence, why would they be going through this process?
I explained my reasoning, great company, they already own 40%, there was a lot of synergy between the businesses, it was pretty cheap, NOC had tons of cash, they could still have access to the testing and could make money on renting out testing to others. IF all this were true, which we knew it was, THEN why wouldn’t Northrop buy Scaled Composites?
He actually got a little annoyed at my argument and wouldn’t even entertain the idea as a possibility. And, this was a very level-headed analytical guy. I later figured out what I believe was the problem. He was lost in the smoke and couldn’t see the fire.
He had become so entrenched in the details of what we were doing, that he lost sight of the big picture. I don’t know, but he may even have been told by management at Northrop Grumman that they would never buy the rest of Scaled Composites. Doesn’t matter. You’ve got to be able to “hear” the people in charge, but not necessarily “listen” to what they have to say.
A few weeks after this conversation, as we were gearing up to travel to Mojave, we were told the project was complete. Northrop had bought Scaled Composites.
You can do quite well applying some If/Then logic to big picture stock investing and trading. Common sense can land you some great returns, especially in areas where you have even a little expertise. (But don’t take it just from me, a lot of this thinking is laid out in Peter Lynch’s classic, Beating the Street.)
“Run It Out” Application
Now with one famous example and one personal example, let’s do a “Run It Out” exercise with one of my favorite topics these days, Phunware warrants (PHUNW).
In the case studies above I focused mainly on the positives of doing an IF/THEN analysis. But it’s just as, if not more, important to identify the “Nightmare Scenario” as well.
What is the IF/THEN that will result in your position losing 50-100% of its value. Yep, been there, done that (when I was MUCH younger), and if you haven’t I guarantee you it’s not something you want to do again.
I’ve talked about the positive scenarios for PHUNW here and here. So what is the nightmare scenario if you’re long the warrants?
Let’s quickly revisit the terms.
- The warrants are exercisable at $11.50 for one share of PHUN.
- The shares underlying the warrants are not registered, and therefore the warrants are not currently exercisable (and therefore the warrants trade at a HUGE discount to the common).
- There is a redemption clause allowing the company to call the warrants if the common trades above $21 for 20 out of 30 trading days.
In my other posts you may have noted that I’m positive on the warrants, eg, I have a long position in PHUNW. But, you may have also noticed that I have what I call a lottery ticket position. Which I explained, is a very small position, and if it goes to $0 (nightmare scenario), no big deal.
A LOT of people have asked me different questions about the warrants. And, I’ve taken it upon myself to correct some incorrect statements about the warrants I’ve seen posted online.
But, no one has asked me why I have a very small position in the warrants if I believe they will move up. Did YOU wonder why I have a small position?
It’s because of the nightmare scenario. The nightmare scenario, almost by itself, informs the amount of risk I’ll take in the position. NOT the “how much can I make” scenario. Reread that if you need to, it’s the most important point in this (OMG, how long is this post going to be) post.
Nightmare Scenario 1
First, I think this scenario is very unlikely. Phunware management could fail to register the shares underlying the warrants. This would make the warrants impossible to exercise, as they are now.
I find this unlikely because the SEC documents filed by Phunware say they will undertake their best efforts to register the shares, and it’s not a big push to get this done. And, if they don’t register them, there will be lawsuits, and it all gets ugly.
Plus, Phunware gets mo’ money if they do have investors exercising the warrants. So this scenario, while possible, really doesn’t make sense and has an extremely low probability.
Nightmare Scenario 2
This scenario is quite possible, and I would not be at all surprised if it were to occur. And, this is why I have a lottery ticket style position (read very low risk for me) on in the warrants.
In this scenario Phunware registers the warrants, and on the same day (or very soon thereafter) calls the warrants for redemption. I know 100% that one thing is going to happen. When the warrants are registered, the price of the common stock is going to drop. Supply…demand…that class in Econ 101, yeah, I can see it coming back to you.
In nightmare scenario 2 that drop takes the common down through $11.50. Uh-oh. And then, as my mother-in-law likes to say, the warrant holders are “toast, baby”. Don’t ask.
IF the common drops below the strike, AND the warrants are no longer 5 year warrants, but 30 day warrants, THEN we’re in trouble. It may not happen, but it can. And, it’s one of the reasons the warrants are trading here below $1.
And on the flip side, IF the stock stays above $11.50, THEN I’ll be scaling out of the warrants as they rise to trade in line with the common.
If you’d like my take on more IF/THEN scenarios, and which warrants I believe IF you buy them THEN they will make you money, sign up for my monthly newsletter here. Our first pick from the inaugural edition, WTRHW is up 34% in a few weeks.