Substack-native post can be found here: https://mtcapital.substack.com/p/the-importance-of-asymmetry

In theory, the fundamental building blocks of the universe, matter and anti-matter, should exist at a 1:1 ratio, a positron for every electron, a yin to each yang. However, owed to some miraculous flaw in the simulation’s code, a perturbation in the motion of the universe’s marionette, this is not the case. Rather than the big-bang resulting in the almost immediate annihilation of matter and anti-matter into photons, matter prevailed, surviving in excess to its counterpart. Each grouping of matter, ranging from a tiny grain of sand, to the planets and their moons, is attributable to this glitch in the system. We owe our existence to asymmetry.

Asymmetry is not only beneficial to life itself, but to the art of portfolio construction as well. Some of the best types of exposures to have in investing are those with asymmetry; small bets made with these inherent characteristics can improve risk-adjusted returns over the long run, promote robustness, and enforce the foundations of anti-fragility.

Their usefulness is directly tied to the fundamental characteristics of their payoff function. Functions with larger gains than losses are what is known as non-linear convex. Negative outcomes associated with variable x cause small or relatively harmless amounts of pain, whereas outcomes on the positive end of the spectrum generate gains that are much larger in magnitude in comparison. In other words, these payoff functions have capped downside with largely uncapped upside.

Option traders commonly make use of these principles. Over the long run, participating in trades that loose a small amount of capital frequently, but generate large expected payouts during infrequent periods of heightened volatility or market turmoil, can counterintuitively improve the robustness of a portfolio.

In well-run businesses, similar types of behavior can be observed. Some companies devote a certain % of R&D each year to technological tinkering. Others may deploy a new product line in certain retail locations, pursue a sales & marketing strategy that is largely unexplored, or test their luck in a new geography. There is something to be said about devoting a small percentage of capital each year to new endeavours. Efforts such as these could very well lead to outcomes that were far from expected, and help to improve business quality over the long run.

The fact of the matter is, incorporating entities or instruments that embrace these principles into a portfolio arguably vastly improves one’s ability to expose themselves to events with positive upside potential. I can think of no better example of a company that continues to do just that than the King of the Gold Royalties Industry - Franco Nevada ( FNV 2.04%↑ ).

Franco Nevada was founded in 1983 by two individuals, Seymour Schulich and Pierre Lassonde, of whom had the intention to start a mining operation. Seymour began his career as an oil analyst at the Canadian Investment firm Beutel, Goodman & Company. As he earned his chops, he started to recognize the power of the royalty model that was commonly used throughout the oil and gas industry, particularly how these agreements generated phenomenal returns on capital. With this in the back of Seymour’s mind, and despite their desire to become a mining entity, in 1986 the two decided to purchase a gold royalty atop a small property in Nevada for around $2M, a location that was expected to yield approximately 500K ounces of precious metal. Shortly thereafter, the two started to benefit from asymmetry. Barrick Gold purchased the mine atop the property for $75M, and conducted additional exploration and deep-drilling. The expectation that 500K ounces of precious metal could be dug out of the ground quickly turned out to be an enormous underestimation of the site’s potential. Over the next few decades, north of 50M ounces of precious metal were able to obtained from this property. A $2M royalty investment has now generated more than $1B in revenue for Franco Nevada.

Over the last few decades, Franco Nevada has amassed a portfolio of hundreds of these instruments. Their payoff functions are uniquely asymmetric, and when analyzed in an extremely over-simplified manner arguably have three outcomes. The first (though unlikely) outcome is that the investment turns out to be an epic failure. Production doesn’t turn out as intended & the royalty has to be written off as a zero. The second more likely outcome is that the investment behaves as intended and Franco Nevada benefits from steady cash inflow as the assets continues to operate and produce. The third outcome is expectations are exceeded, such as scenarios where additional and unintended production capacity is brought online, an unknown reserve is stumbled upon, etc. I can think of no better portfolio company that offers such clear exposure to positive, asymmetric outcomes. My next in-depth research report will go much deeper into the company’s financials, prospects, and why I believe this is the best way to get exposure to gold in an equity-centric portfolio.

Until next time,

MT Capital Research.