Investing in the World of Information Voids
Investors will never be able to access the entire story of a business. Invest accordingly.
Many of the companies profiled here can be labeled as “ships and nuclear plant” companies. Their names will never appear in the headlines of major news outlets unless something goes spectacularly wrong.
So, when FTI Consulting (NYSE: FCN) was featured in one of Financial Times’s top stories over the weekend, you immediately knew it wasn’t good.
The quick and dirty story is that a former employee, Jon Orszag, created a rival economic consulting firm. Orszag was poaching several FTI employees (“top lieutenants,” as FT described them) to join this new firm.
The story itself wasn’t some earth-shattering news, although the company’s stock did fall precipitously after the rival firm was announced and FTI’s management said 2025 would likely be a challenging year.
Instead, it highlights a key component of investing: The unknown unknowns.
As absurd as the statement above was when the Secretary of Defense of the United States said it, it contains an enlightening investing lesson.
We will miss something no matter how much due diligence we do on a potential investment.
In the case of FTI Consulting, the most surprising thing was how most individual investors were likely unaware of such a situation unfolding (unless they have a lot of scuttlebutt on consulting firms). I am a shareholder and was a little blindsided by the announcement.
At first, I assumed I was careless in my due diligence. How could I not at least be aware of such a key employee that could incite a mass exodus of FTI staff?
The port-mortem analysis of this situation is I could have spent months looking for the risk and not found it. FTI never issued a press release or filed an SEC disclosure containing Jon Orszag’s name over the past 10 years. There wasn't even an 8-K about his termination (he wasn’t a named executive officer). Aside from the most recent news articles, it took going to page four of Google search results to find a December 2023 Global Competition Review article stating Orszag was terminated with cause for threatening to launch a rival firm as a bonus negotiation tactic.
FTI Consulting is a people business, so attracting and retaining talent is a cornerstone to its success. The company admits to as much in its 10-K and states in its risk factors that its Economic Consulting division, the one in which Orszag worked, has higher expenses because of unique contractual payouts to its economists and professionals. However, I don’t know how many people would interpret this as “an employee of this segment may form a rival firm and pluck a large portion of our personnel.”
Based on the market reaction to the news, it’s fair to say that both individual and institutional investors weren’t aware of the situation (a real poke in the eye for the "efficient market” crowd).
This isn’t an indictment of anyone’s analysis. Instead, it is a reminder that every company has unknowable and unpredictable risks. Even with companies where we have spent a considerable time doing due diligence, we probably have, at best, 60%-70% of the complete picture. The only thing that could give us absolute certainty about a stock is a time machine. Even then, we’d probably make some mistakes (you know, butterfly effect).
The unknown unknown risk is what makes investing so lucrative, though. We are willing to place significant portions of our personal savings into uncertain outcomes and are rewarded with higher rates of return for our vote of confidence. We do what we can to select our investments with a reasonable amount of information to make a rational decision, but risks like the former employee quietly poaching staff will always catch us unaware.
Ultimately, this is another example that reinforces two key tenants of prudent investing:
Diversification is protection against ignorance
Yes, I’m doing that cliche financial writing thing and blatantly quoting Warren Buffett. But I have to because 1) this line is a banger, and 2) 95% of the investing world misinterprets it. Most investors view this line as justification to own a select few companies (I’m no dummy, I don’t need to take the same precautions as the proletariat).
Many people seem to miss that the person giving the “ignorance insurance” advice runs a portfolio with over 200 wholly or partially owned businesses.
Ignorance in this case isn't a litmus test of one’s intelligence, it is an acknowledgment of the unknown unknowns that can turn a well researched idea into a portfolio dud.
Valuation matters for everything
Despite the COVID panic in 2021 and whatever we want to call the 2022 decline, returns for the post-Great Recession period have been a sight to behold. This period's 15% annualized returns are in the top quintile of 15-year stock performances over the past century.
Returns like this can lead us to let our guards down regarding valuation. Unrelenting bull markets mean the term “growth at a reasonable price” becomes perverted to the point where somewhere on the internet you can find someone saying Costco (NASDAQ: COST) is “a bargain” at an earnings yield of 1.6%.
We may all be willing to pay the quality premium, but even quality stocks have unknown unknowns. Our capital allocations have to reflect some uncertainties, as minuscule as those uncertainties seem in the moment.