A 1981 Wargames Strategy Applied To Investing

Portfolio construction gleaned from an A.I. guided victory - Antifragile

Carlos Velásquez · Medium · 7 min read · Image by Pixelharvester from Pixabay

On July 4, 1981, a 29-year-old Stanford University computer scientist named Doug Lenat entered the Traveller Trillion Credit Squadron tournament in San Mateo, California. Contestants were allocated an imaginary budget of a trillion dollars to build warships that partook in battle via knockout rounds to determine the winner. Most of the contestants’ fleets resembled those used in real-world conventional warfare, consisting of variously sized warships capable of defending themselves.

Lenat adopted a different strategy.

He fed the tournament rules to an Artificial Intelligence program he developed. After some tweaking of the parameters, it guided him to deploy an enormous flotilla of tiny ships with ample firepower but entirely devoid of defensive ability. Lenat’s ships were sitting ducks opponents could easily sink — his opponents just couldn’t sink all of them before being overwhelmed by his flotilla’s cumulative firepower. Lenat easily won the tournament.

As an investor, I find stories of conventional wisdom turned on its head intriguing as they often contain lessons applicable to my investment philosophy. Lenat’s 1981 AI-guided gamesmanship is an example of utilizing pattern recognition to systematize decision-making under uncertainty — an approach that can be profitable when applied to portfolio construction. Consider the following:

  1. Small-cap stocks can be analogous to tiny warships with ample firepower.
  2. Portfolio construction is comparable to a fleet deployment strategy.
  3. The stock market, like a war theater, is fraught with uncertainty.

Economic surprises — what Nassim Taleb refers to as “positive Black Swan events” — can cause a subset of small-cap stocks to reap exponential returns. Such surprises are the reason a portfolio consisting of hundreds of small-cap stocks, each embedding asymmetric risk-reward potential, can outperform market indexes in the long run.

1. Small-Cap Stocks | Tiny Ships With Firepower

Asymmetric Risk-Reward Potential In Small-Cap Stocks

Small-cap biotech companies generate little if any revenue during the R&D phase, making some of the metrics investors use to value stocks immaterial in the biotech space. Given these companies’ diminutive market capitalization, the media and institutional investors rarely follow them. This lack of analytical rigor increases the chance of periodic asset price inefficiencies. Exponential stock price appreciation can occur when a biotech company’s drug/treatment gains FDA approval. Other types of small-cap stocks with similar asymmetric risk-reward profiles exist among commodity and chemical producers, software, semiconductors, equipment, fabrication, and digital asset companies. The risky, often speculative, nature of the underlying business models makes this type of portfolio potentially more volatile than the broader market. However, proper position sizing and temporal diversification can mitigate this concern. The portfolio companies that thrive will drive returns, the stock market equivalent of the tiny unsunk ships that earned Lenat the 1981 tournament victory.

2. Portfolio Construction | A Fleet Deployment Analog

Lenat’s 1981 gamesmanship embeds a systems-thinking analog that can be replicated in portfolio construction. This analog lends itself to the systematic utilization of investment heuristics that help investors gauge market sentiment toward a stock. Fortunately, A.I. programming skills are not required.

Company Insiders Purchase Activities

Company insiders are best positioned to understand the intrinsic value of their company. The bullish among them often buy their company’s stock, even as its price drops in value. Simultaneous purchases by multiple high-ranking insiders — i.e., CEOs, COOs, CFOs, and Directors — provide a bullish signal, particularly when corroborated by other metrics (see below). Large stock purchases relative to an insider’s annual salary provide an especially bullish indication. Dataroma.com is one source to find company insiders’ trading activities.

Why this heuristic is relevant: company insiders will purchase their company’s stock if they deem it is undervalued. Or as Nassim Taleb states…

“…Don’t tell me what you think, tell me what you have in your portfolio.” ~ Skin in the Game, Hidden Asymmetries in Daily Life

Current Ratio: Absolute Level & Change

The current ratio measures a company’s ability to meet its financial obligations over the next 12 months. Higher current ratios are favorable. The current ratio can be found in the balance sheet statement (or Yahoo Finance’s balance sheet summary, under “statistics”). Investors can augment this insight by tracking the current ratio over several quarters, which can help corroborate the other signals being tracked.

Why this heuristic is relevant: cheap well-financed stocks tend to experience mean reversion in share price — refer to William Green’s conversation with Joel Greenblatt at the 45:00 minute mark.

Analysts’ Ratings: Track Their Changes

Financial services firms’ stock ratings can be questionable. However, tracking multiple analysts’ stock ratings of a particular stock over several quarters can be insightful. A strong signal results when a stock’s rating trends similarly among various analysts incorporating different metrics and rating styles. (Rating analysts do not follow some small-cap stocks; in such cases, filtering for stocks with a strong current ratio is increasingly important. Anecdotally, higher-rated stocks typically have higher current ratios.)

Why this heuristic is relevant: tracking analysts’ rating changes can corroborate a stock’s positive sentiment signals you may have already detected (i.e., insider’s purchase activities and a strengthening current ratio.)

Margin Of Saftey: Buying At The 52-Week Low Or All-Time Low Price

When combined with the above signals, a stock’s 52-week price low (or all-time price low, if it has occurred within the last five years) can serve as a price floor around which to place buy limit orders. *Tiered limit orders at or below 52-week/all-time low price levels enable investors to systematically incorporate a margin of safety by utilizing a stock’s inherent volatility to trigger purchases at favorable prices. No transaction fees and streamlined trading platforms make entering thousands of limit orders on hundreds of stocks feasible. [*Tiered limit orders herein: exceedingly larger resting buy orders that trigger when the stock drops in value.]

Why this heuristic is relevant: among large-cap stocks, 50% price swings occur during years of low volatility, and 200% price swings occur during years of high volatility years — see (Oakcliff Capital) Bryan Lawrence’s interview at the 18:00 minute mark. Since small-cap stocks are more volatile than large-cap stocks, investors may benefit from the inherent volatility in small-cap stocks by placing limit orders at exceedingly lower price points.

3. Stock Market | War Theater: Fraught With Uncertainty

Lastly, imagine you are a professional investor with $250 million in Assets Under Management. As long as you consistently outperform the relevant benchmark, the 1.5% annual fee your AUM generates will enable you to continue making a comfortable living.

But now envision market volatility rising suddenly, ala March 2020.

Clients start calling to voice concerns about the potential of permanent capital impairment to their portfolios. Word on the Street is that your professional peers are increasingly going to cash. You’re keenly aware that some of the stocks you’ve been following are at oversold price levels. However, you’re concerned that your portfolio could drop another 25%, if not more, before the market stabilizes. Would you buy the stocks in which you still have long-term conviction? Or are you better off going to cash as quickly as possible?

During times of market uncertainty, money managers tend to convert their AUM to cash out of fear that their clients will pull money out of their funds, augmenting the downward pressure on asset prices.

Market Volatility: The Rule, Not The Exception

Data: finance.yahoo.com / Graph: Produced by Author (*The first 500 Index fund was offered by Vanguard on December 31, 1975.)

Before Russia’s February 2022 invasion of Ukraine, an 81-year old who had invested in the broader U.S. stock market since the 1961 Cuban Missile Crisis would have experienced the following drawdowns:

  • 19 drawdowns of 10% or greater (1-in-3 years)
  • 9 drawdowns of 20% or greater (1-in-6 years)
  • 6 drawdowns of 30% or greater (1-in-10 years)
  • 3 drawdowns of 40% or greater (1-in-20 years)

During macroeconomic and geopolitical events, intraday price volatility of individual stocks increases much more than depicted in the “S&P 500 Percentage Drops: Peak-To-Trough” graph above. For small-cap stocks, price volatility is greater still, creating buying opportunities for investors with dry powder, a game plan, and an understanding of the stock market’s history.

Portfolio | Fleet Construction: The Analog’s Takeaway

Unexpected global events create the stock market conditions under which Lenat’s tiny ship analogy for portfolio construction is apt. This type of portfolio construction is also relevant when attempting to take advantage of company-specific volatility (i.e., when a stock’s price volatility is driven by the confluence of margin calls, block trades, light volumes, short/long-squeezes, etc.). These phenomena are the reason why systematically placing buy limit orders at favorable prices on hundreds of small-cap stocks that embed asymmetric risk-reward potential can provide patient buy-and-hold investors a long-term edge.

Author also wrote: Fooled By Randomness | Our Airbnb Experiment | Wealth Transfers | 5 Stocks: S&P’s YTD | Inflation Hedges | An 80-Year Life | 13 Rules | N. Taleb’s Minority Rule | Your Inner Voice | Bitcoin’s Volatility | Blockchain Stocks |50 Investment Lessons | Flywheel Effect | Bitcoin: Mental Framework | Crypto Moonshots | 4 Crypto Stocks | Bitcoin: Insurance | Brief History: Money | Spontaneous Order | Ackman’s $2.6B Moonshot | Fragility Inducing Events | Antifragile: Definition | 1% Bitcoin: 99% Cash | COVID-19: Market

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Disclaimer: Topics covered herein are for informational purposes. Before acting on investment information, consult with a financial professional.

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