I recently published an investment thesis exclusive to the investment platform, Seeking Alpha, where I will be covering recent and forthcoming initial public offerings (IPOs). The article is on the American investment advisor, Diamond Hill Investment Group, Inc. . From the executive summary of the article is the following:
Diamond Hill faces secular headwinds from passive investing, fee compression, and industry competition, leading to declining profits and revenue over the past five years.
Despite these challenges, Diamond Hill’s disciplined, value-oriented approach and strong alignment between management and shareholders offer some resilience and capacity discipline.
The market appears overly pessimistic, pricing in a 14% NOPAT decline; modest upside exists if declines are less severe, with potential 7-20% returns.
I rate Diamond Hill a Buy for short-term benchmark-beating potential, but caution that long-term prospects remain challenged by structural industry shifts.
I recently published an investment thesis exclusive to the investment platform, Seeking Alpha, where I will be covering recent and forthcoming initial public offerings (IPOs). The article is on the American security products company, CompX International Inc. (CIX). From the executive summary of the article is the following:
CompX International is rated a sell due to declining financial performance since 2022, despite a seemingly reasonable valuation and alignment of shareholder-management interests.
The business is simple and resilient to tariffs, with a significant portion of its revenue from U.S.-manufactured security products and marine components.
Despite tariff resilience, CompX’s financials show a concerning decline in revenue and NOPAT, suggesting it may not meet market expectations.
Valuation analysis indicates significant downside risk if revenue and NOPAT margins do not improve, making CompX a potential value trap.
I recently published an investment thesis exclusive to the investment platform, Seeking Alpha, where I will be covering recent and forthcoming initial public offerings (IPOs). The article is on the Chinese maker of skincare products targeted at people with “problematic skin”, Park Ha Biological Technology Co., Ltd. (PHH). From the executive summary of the article is the following:
Park Ha Biological Technology operates in a large, fast-growing market but faces intense competition and rising costs, impacting profitability and free cash flow.
The company’s dual-sales strategy and diverse product range enhance customer retention, but declining franchise numbers raise sustainability concerns.
High insider ownership aligns interests but increases stock volatility, while capital controls in China pose risks to accessing funds.
Current valuation implies a 3,492% NOPAT growth, making the stock a “Hold” due to profitability challenges and valuation risks.
(This investment thesis also appears on the buy-side investment platform, SumZero.)
The choking uncertainty around U.S. economic policies caused me to abandon Meta Platforms, Inc. (META: $592.49/share) with all the grace of a dog caught ripping up the sofas. This uncertainty opened up a possibility that seemed inconceivable before: that Meta might be grievously harmed. That oft-quoted remark, oft misattributed to Vladimir Lenin, “There are decades where nothing happens; and there are weeks when decades happen”, came to mind. The recent announcement by U.S. Secretary of the Treasury, Scott Bessent, that the United States and China have agreed to swingeing albeit temporary cuts to existing tariffs, leaving them at the baseline rate of 10% for Chinese tariffs on US goods and 30% for US tariffs on Chinese goods -10% baseline plus the fentanyl-related tariffs-, has made U.S. markets and Meta specifically, more palatable. That announcement provides a safe entry point for the firm I believe is the most compelling investment proposition among U.S. large caps, a business I have long admired, and sometime held.
A History of Exceptional Growth and Profitability
It is easy to see why Meta generally trades at a premium to its economic book value. From 2011 to the last twelve months ended in the first quarter of this year, Meta compounded revenue by 31.43% a year, and compounded net operating profit after tax (NOPAT) by 33.69%. Meta’s exceptional performance has carried on even in the last five years when it has been one of the largest companies ever, with the company having a 5-year sales CAGR of 14.66% -Credit Suisse’s “The Base Rate Book” shows that just 3.3% of firms with a market cap of over $50 billion enjoyed a 5-year sales CAGR of more than 10-15% between 1950 and 2015- and a 5-year NOPAT CAGR of 10.2%. Meta’ return on invested capital (ROIC) has averaged 31.71% in that time, with current ROIC at 31.79%. In that long history, management has never failed to earn an economic profit. Exceptional growth and profitability are a byproduct of the business.
Baseline Tariffs are Acceptable
At former levels, tariffs on China were in effect so high that they act as a trade embargo, an act of decoupling. Temu and Shein, who are responsible for the majority of Meta’s Chinese ad revenue, have both already slashed their U.S. ad spending in response. Analysts at MoffettNathanson Research warned that tariffs on China would reduce Meta’s Chinese revenue by $7 billion, although I worried that not only could Meta lose all its Chinese revenue, which in 2024 was $18.35 billion, according to its annual report, but that tariffs would hurt businesses so much that Meta’s revenue would be affected by even greater amounts. At the same time, capex spending would become less efficient as inflation eroded the impact of that expenditure. Overall, I worried that the value of the business would fall in expected ways. Indeed, although markets responded euphorically to Meta’s first quarter results, that was largely because expectations had been so low that markets ignored the fact that advertising metrics deteriorated, while economic profits, by my estimate, fell from around $51.53 billion in 2024 to $45.06 billion in the LTM. Maintaining the old regime was clearly unsustainable. For now, those concerns have abated and growth and profitability should do better than where I imagined they were headed. At current levels, tariffs are an acceptable cost of business.
I do not believe that baseline tariffs will be removed. It has been my contention for some time that tariffs are here to stay, and that of all the nations in the world, tariffs on China will be the hardest to remove. In an earlier thesis, I explained that,
…regardless of one’s opinion on tariffs, the Trump Admin. has powerful motives for supporting them:
The China Shock has gutted the manufacturing industries of countries across the world, such that, despite the broad wealth created, working class people have been left behind, stoking populist outrage. Such a system is unsustainable.
In a military contest with China, the economic benefits of a global division of labour pale beside the risks of relying on a trade partner that builds the things that America will need to wage war.
From the perspective of economic competition, the current division of labour is not static, and China can use it to achieve parity with the U.S. in those areas in which the U.S. is currently a world leader. BYD’s stunning success is an example of this.
…it really does not matter if one agrees with the administration’s motives, just that they are powerful enough that one should not expect tariffs to end completely. At a minimum, tariffs on China are likely to stay, even under a Democratic administration, all that is to be decided is the size of those tariffs. The Magnificent Seven, the most profitable businesses in human history, are a third of the S&P 500. Tariffs will erode their profitability and force investors to look elsewhere for investments, and that “elsewhere” will not benefit from the same premiums-to-value that the Magnificent Seven does, and that implies a downward revision in the price of the S&P 500.
Regime uncertainty persists: a comprehensive trade deal cannot be negotiated in 90 days -the fastest ever such deal was with Jordan, and the U.S. took four months to negotiate and the average is one and a half years-, but the U.K. deal framework suggests that the U.S. has shifted from attempting to strike comprehensive trade deals to pursuing small, focused deals that target specific industries. Even so, such deals are typically not conducted within 90 days, and Peter, Lord Mandelson’s framing of the U.K deal as a “platform for going further and opening up more trade opportunities”, not only points to such small, focused deals, but that regime uncertainty of some sort will persist for the next year or more as countries try and reshape the economic order in more favourable ways.
Meta Should Win its Case Against the FTC
The tariff announcement shifts the calculus in another way, placing the Federal Trade Commission’s (FTC) case against Meta at the head of Meta’s biggest risks. The case rests upon a flawed though pervasive theory of competition. In some ways, Meta’s defence of its actions is also flawed, and is responsible for the company’s lethargy in responding to the threat from ByteDnce’s TikTok. In the case summary, the FTC alleges that,
…the company is illegally maintaining its personal social networking monopoly through a years-long course of anticompetitive conduct. The complaint alleges that Facebook has engaged in a systematic strategy—including its 2012 acquisition of up-and-coming rival Instagram, its 2014 acquisition of the mobile messaging app WhatsApp, and the imposition of anti-competitive conditions on software developers—to eliminate threats to its monopoly.
Meta has made Instagram and WhatsApp better, more reliable and more secure through billions of dollars and millions of hours of investment.
Moreover, she has said what is obvious to many, that Meta has just 30% of time spent in its properly defined market, in which it faces competition, not just from “Snapchat and an app called MeWe”, but also from TikTok and YouTube. In 2020, she called the case, “revisionist history”, writing that, having acceded to both acquisitions,
Now, many years later, with seemingly no regard for settled law or the consequences to innovation and investment, the agency is saying it got it wrong and wants a do-over. In addition to being revisionist history, this is simply not how the antitrust laws are supposed to work. No American antitrust enforcer has ever brought a case like this before, and for good reason. The FTC and states stood by for years while Facebook invested billions of dollars and millions of hours to make Instagram and WhatsApp into the apps that users enjoy today. And, notably, two FTC commissioners voted against the action that the FTC has taken today.
This is closer to reality, but does not fully comprehend the problem, because even Mark Zuckerberg has fallen into the same error. From his 2012 letter in advance of then-Facebook’s listing, he said,
Facebook was not originally created to be a company. It was built to accomplish a social mission — to make the world more open and connected.
This is both correct, and wrong. Meta is not, ultimately, a social media company, and framing it as such leads to the sorts of confusions that cloud the FTC’s case, because a social media company, or “personal social networking monopoly” to borrow the FTC’s nomenclature, cannot compete with a video-sharing service such as TikTok, unless they are in the same industry. TikTok is not a social media company, after all. The FTC’s deliberately narrow view of Meta creates this logical problem and compels a denialism about the extent of competition faced by Meta. Ben Thompson of Stratechery has tried to get round this by characterising Meta as evolving through “three eras”, with this being an era of competition. I think this is still off. The social media business is at once the core of Meta’s business and a deux ex machina to compete in the Attention Economy.
A consequence of taking a complexity approach to competition is that competition is seen as a multi-level process, in which firms compete and relate with other firms within an industry, who, given the tendency of wealth toward destruction, seek to survive over the long-run and grow in the short run. Within markets, firms maximise their profits and compete for market share by providing sustainable products and services. Competition between firms can also be described in Coasian language as competition between intra-firm and inter-firm organisation, between whether economic activities should be done within the firm, or by the market. Within firms, individuals, units and divisions compete and cooperate to maximise their individual payoffs. Nicolas Petit and Thibault Schrepel call these the macro, meso and micro levels of competition. Competition at the industry level forces changes within firms that result in a firm facing new competitors at the market level. Concretely, by way of example, each of Meta Platforms divisions compete and cooperate over resources, and at the market level, Meta enjoys a monopoly in social media networks, but faces fierce competition at the industry level, where it is part of the Attention Economy. …The emergence of TikTok at the industry level forced changes in Instagram, by way of Reels, which triggered an evolution from a chronological feed of content surfaced from one’s social network to algorithmically sorted content from the universe of all Instagram users.
Meta’s error in not quickly recognising TikTok as a threat, was because Meta itself fell into the error of seeing itself as a social media company and therefore not existing in the same competitive landscape as TikTok. TikTok, after all, was not built on social networks but on algorithmically surfaced content. Calling TikTok or indeed YouTube a social media company, is a stretch if the intuitive sense of the phrasing implies the necessary existence of social networks. What Meta is is a business in the Attention Economy, where, regardless of the deux ex machina that brought one there, the battle is fought for attention, i.e. time spent, and victory is measured in advertising dollars. Meta is not completely oblivious to this. In the first quarter earnings call this year, Susan Li, the CFO, said,
There are two primary factors that drive our revenue performance: our ability to deliver engaging experiences for our community, and our effectiveness at monetizing that engagement over time.
There’s that old saying, “Follow the money”, and in Meta’s case, that proves remarkably revealing in understanding what the business actually is, as opposed to how it is framed. Although Meta’s defence fails to fully reframe what the company is, the weakness of the FTC’s case is such that it is unlikely to succeed, because, ultimately, in order for a final judgment to hold that the company operates an illegal monopoly, it must ignore the competition the company faces.
There is also the rather mundane fact that the deals to acquire Instagram and Whatsapp were both vetted by the FTC and at the time, it was not clear that a monopoly existed or was being created and that it would become so profitable.
Meta is Well Placed to Profit from AI
In the first quarter earnings call this year, Mark Zuckerberg highlighted the importance of AI to Meta in terms of “improved advertising, more engaging experiences, business messaging, Meta AI, and AI devices”, pointing out that Meta does not need to succeed everywhere to enlarge its returns. The most important of these opportunities in terms of immediate investment results lies with advertising, with Zuckerberg explaining that,
Our goal is to make it so that any business can basically tell us what objective they’re trying to achieve — like selling something or getting a new customer — and how much they’re willing to pay for each result, and then we just do the rest. Businesses used to have to generate their own ad creative and define what audiences they wanted to reach. But AI has already made us better at targeting and finding the audiences that will be interested in their product than many businesses are themselves, and that keeps improving. And now AI is generating better creative options for many businesses as well. I think that this is really redefining what advertising is into an AI agent that delivers measurable business results at scale. And if we deliver on this vision, then over the coming years I think that the increased productivity from AI will make advertising a meaningfully larger share of global GDP than it is today.
In the post-App Tracking Transparency world, Meta’s success has been built on its ability to deploy machine learning tools to probabilistically target users. Without realising it, Apple’s ATT policy may have hurt Meta in the short-term, but, in the long-term, widened Meta’s proverbial moat, by denying social media networks such as Snap access to the data needed for deterministic ad targeting. Meta has the scale and infrastructure to make the best probabilistic targeting available. With generative AI, this competitive advantage becomes even stronger: Meta will be able to test an infinite number of ad ideas and verify the success of each ad, pushing that probabilistic process closer toward certainty. With the scale and infrastructure available to meta, the company will be able to take over the entire creative process for advertisers, with even greater success than it now has, which will attract more advertisers, raising prices and margins. Already, the AI recommendation model Meta is testing on Reels has led to a 5% increase in conversions and has been used by 30% of advertisers.
I cannot conclude this section without mentioning DeepSeek: although investors reacted negatively to it, as a kind of external shock, it is actually favourable, at least to Meta. Meta does not need the Llama family of open-weight models to be the world’s best generative AI tool, what it needs is for the cost of generative AI to sharply decline as models improve, and for content to become even more commoditised. In a 2024 interview with Dwarkesh Patel, Zuckerberg noted that,
there’s multiple ways where open source could be helpful for us. One is if people figure out how to run the models more cheaply. We’re going to be spending tens, or a hundred billion dollars or more over time on all this stuff. So if we can do that 10% more efficiently, we’re saving billions or tens of billions of dollars. That’s probably worth a lot by itself. Especially if there are other competitive models out there, it’s not like our thing is giving away some kind of crazy advantage.
…
Here’s one analogy on this. One thing that I think generally sucks about the mobile ecosystem is that you have these two gatekeeper companies, Apple and Google, that can tell you what you’re allowed to build. There’s the economic version of that which is like when we build something and they just take a bunch of your money. But then there’s the qualitative version, which is actually what upsets me more. There’s a bunch of times when we’ve launched or wanted to launch features and Apple’s just like “nope, you’re not launching that.” That sucks, right? So the question is, are we set up for a world like that with AI? You’re going to get a handful of companies that run these closed models that are going to be in control of the APIs and therefore able to tell you what you can build?
For us I can say it is worth it to go build a model ourselves to make sure that we’re not in that position. I don’t want any of those other companies telling us what we can build. From an open source perspective, I think a lot of developers don’t want those companies telling them what they can build either. So the question is, what is the ecosystem that gets built out around that? What are interesting new things? How much does that improve our products? I think there are lots of cases where if this ends up being like our databases or caching systems or architecture, we’ll get valuable contributions from the community that will make our stuff better. Our app specific work that we do will then still be so differentiated that it won’t really matter. We’ll be able to do what we do. We’ll benefit and all the systems, ours and the communities’, will be better because it’s open source.
In the wake of DeepSeek’s launch, Zuckerberg said he believed that not only could Meta incorporate some of the novel things DeepSeek did, which, presumably, would mean that spending would become more efficient, but also that,
There’s going to be an open-source standard globally, and I think that for our own national advantage it’s important that it’s an American standard. The recent news has only strengthened our conviction that this is the right thing to be focused on.
In effect, this would free Meta from the kinds of dependencies it had on Apple, while making more developers dependent on Meta.
Income Statement: I made $6.63 billion in adjustments to calculate NOPAT, with the net effect of deducting $3.65 billion in non-operating income. The adjustments are equal to 9.95% of Meta’s GAAP net income.
Balance Sheet: I made $138.36 billion in adjustments to calculate invested capital with a net decrease of $83.54 billion. One of the largest of these adjustments was $72.99 billion in excess cash, an adjustment worth 26% of reported assets.
Valuation: I made $136.79 billion in adjustments with a net effect of increasing shareholder value by $9.19 billion. The largest of these adjustments was $63.8 billion in adjusted total debt, representing 4.28% of Meta’s market cap.
Position closed on 13 May 2025, at a loss of 1.4%.
Orge Enerji Elektrik Taahhüt Anonim Sirketi (IST:ORGE, ₺108.20/share) is a compelling investment opportunity within the Turkish electrical contracting and renewable energy sectors. Orge Enerji earns a very attractive rating according to my stock rating methodology, thanks to its ability to grow revenue and profitability at quite astonishing rates, in fairly competitive markets, a feat made possible by its competitive advantages.
A Moderately Competitive Industry
The Turkish construction market, within which the electrical contracting industry operates, is characterized by a high degree of competition, with numerous companies vying for projects across various sectors. However, at the electrical installation industry level, the degree of competition appears to be more constrained. Similarly, the electrical equipment manufacturing sector in Türkiye also exhibits a moderate level of competition. Several major players dominate the electrical contracting market in Türkiye, including well-established conglomerates such as Girisim Elektrik Sanayi Taahhüt ve Ticaret A.S. (IST:GESAN), Astor Enerji A.S. (IST:ASTOR), and Kontrolmatik Teknoloji Enerji ve Muhendislik A.Ş. (IST:KONTR). While precise market share data for the electrical contracting industry is not readily available, the presence of these multiple established companies suggests a market that is relatively fragmented rather than dominated by a few major players. Over the last five to six years, the Turkish energy sector has witnessed a notable increase in the participation of private sector entities, signaling a continued liberalization of the market.
In the rapidly expanding renewable energy sector in Türkiye, Orge Enerji’s major direct competitors include firms such as Margün Enerji Üretim Sanayi ve Ticaret A.Ş. (IST:MAGEN), Mogan Enerji Yatirim Holding Anonim Sirketi (IST:MOGAN), and A1 Yenilenebilir Enerji Üretim A.S. (IST:A1YEN). And İnşaat Ticaret A.Ş.’s direct competitors incude firms such as Enka Insaat ve Sanayi A.S. (IST:ENKAI), Tekfen Holding Anonim Sirketi (IST:TKFEN), and Gulermak Aglr Sanayi Insaat ve Taahhut A.S. (IST:GLRMK). This further adds to the view that the company is engaged in fairly competitive markets.
One of the most significant findings in finance is that low asset growth firms outperform high asset growth firms, with investments destroying rather than creating value. Resisting the gravitational pull of the asset growth effect is extremely difficult. A sign of the competitiveness of the market and Orge Enerji’s need to compete through investments is that its total assets compounded by 67.24% a year since 2019, while the firm burnt through -₺42.42 million in free cash flow (FCF) in the same time. Yet, Orge Enerji has created ₺1.94 billion in economic profits, as economic profit margins have fattened. Orge Enerji has indeed been able to defy the gravitational pull of the asset growth effect.
Powering Türkiye’s Future
Orge Enerji is primarily engaged in electricity contracting, offering comprehensive, turnkey services encompassing the design, installation, and maintenance of medium voltage, low voltage, and weak current electrical systems for residential and commercial construction buildings.
The Turkish electrical contracting industry is closely linked to the overall health and growth of the nation’s construction market. This construction market demonstrates promising growth prospects, with expectations of a 3.0% annual increase in 2025 and a compound annual growth rate (CAGR) of 2.5% projected for the period between 2025 and 2029. In terms of market size, the construction sector in Türkiye is substantial, estimated at $173.56 billion in 2025, with a projected CAGR of 5.75% from 2025 to 2030. Within this broader construction landscape, the electrical installation market in Türkiye holds significant value, estimated at €6.6 billion in 2025.
Several key factors drive the growth of this industry, including a steadily increasing demand for energy fueled by Türkiye’s growing population, rapid urbanization, and ongoing industrial expansion. Moreover, the need to upgrade and modernize existing infrastructure across various sectors further bolsters the demand for electrical contracting services.
The Turkish government is actively investing in a wide range of infrastructure projects, encompassing transportation networks, industrial facilities, and a significant push towards renewable energy development, all of which necessitate robust electrical contracting services. The nation’s commitment to increasing the share of renewable energy in its electricity generation mix serves as a particularly strong growth driver for electrical contractors specializing in this area. Consequently, Orge Enerji has expanded into renewable energy, where it provides turnkey installation services for solar power plants, catering to various deployment methods including roof-mounted, facade-integrated, ground-mounted, and agricultural installations, as well as wind power plants. Their renewable energy service extends beyond initial installation to include post-installation warranty support, ongoing maintenance, operational services, and round-the-clock remote monitoring, ensuring the longevity and efficiency of these renewable energy assets.
Orge Enerji also operates a trade division that focuses on the sales, marketing, and trading of a comprehensive range of electrical supplies, materials, and equipment, with a particular emphasis on electrical cables. This trading arm serves both Orge Enerji’s internal project needs and external clients, providing an additional revenue stream and potentially enhancing supply chain efficiencies.
Orge Enerji’s wholly-owned construction-contracting subsidiary, And İnşaat Ticaret A.Ş, was formed in 1985 to meet rising residential and workplace demand on İstanbul’s Anatolian side, and specializes in urban‑transformation feasibility studies,and turnkey construction projects, and has delivered multiple landmark sites.
Reducing Transaction Costs for Clients
As a turnkey contractor, Orge Enerji assumes responsibility for the entire project lifecycle, offering clients a comprehensive suite of services from the initial design and engineering phases through the procurement of necessary materials and equipment, the physical installation of electrical systems and renewable energy infrastructure, the critical commissioning process to ensure operational readiness, and finally, ongoing maintenance and support services. This end-to-end approach simplifies project execution for clients, allowing them to rely on a single, experienced partner for all their electrical and renewable energy needs. As aforementioned, Orge Enerji also actively engages in the trading of a wide range of electrical materials and equipment. This division ensures a reliable supply of quality materials for Orge Enerji’s own projects while also catering to the needs of other businesses and clients in the broader market. This integrated approach, encompassing both contracting and trading, enhances Orge Enerji’s operational efficiency and reduces client costs.
Regulations Are Shaping a More Attractive Market
The regulatory environment governing the Turkish electricity market has undergone a significant transformation over the past two decades. Since 2001, the market has transitioned from a predominantly state-controlled system to one characterized by regulated competition, with the aim of enhancing efficiency and attracting private investment. The Energy Market Regulatory Authority (EMRA) plays a central role in overseeing the market, responsible for issuing licenses to market participants and ensuring fair competition within the sector. The structure of the Turkish electricity market covers various activities, including power generation, electricity transmission -which remains a state-owned monopoly operated by Türkiye Elektrik İletim A. Ş. (TEIAS)-, electricity distribution -which has been largely privatized with regional entities responsible for local networks-, wholesale electricity trading, and retail electricity sales.
Management-Shareholder Incentives are Aligned
Established in 1998, Orge Enerji grows and is built upon decades of family and founder expertise. Orge Enerji began trading publicly on the Istanbul Stock Exchange (IST) in 2012, and, while 52% of the company’s are publicly owned, the founding partner, chairman and CEO, Mr. Nevhan Gündüz, owns 17%, and co-founder and vice chairman, Mr. Orhan Gündüz, owns 31%.
Executive directors (Orhan Gündüz and Nevhan Gündüz) each receive a gross ₺30 000 monthly retainer; non‑executive directors receive ₺6 750 gross per month. The group of “Üst düzey yöneticiler” (the board plus the CEO) received ₺906 003 in benefits in 2024, and ₺3 052 969 in travel/representation expense reimbursements. Remuneration is not tied to financial or operational KPIs, nor are there disclosed stock‑option or bonus schemes. The primary mechanism for incentivising the Messrs. Nevhan and Orhan Gündüz are through their shareholding. As a founder-led, family owned business, management’s incentives are in harmony with those of the investing public.
An Experienced and Reputable Deliverer
Orge Enerji possesses a significant competitive advantage stemming from its extensive experience in the Turkish electrical contracting business. The company’s operational history spans over 25 years since its founding in 1998, but this is built upon an even longer legacy of 51 years of family and founder experience in the sector. This longevity has allowed Orge Enerji to cultivate a strong reputation in the market, known for its consistent track record of completing projects on time, adhering to high-quality standards, and offering optimal pricing that reflects the value and reliability of its services. Over its history, Orge Enerji has successfully delivered a multitude of major projects across a diverse range of sectors, including infrastructure, commercial, residential, and industrial developments. This proven ability to handle complex and large-scale projects enhances its credibility and makes it a preferred partner for clients seeking reliable electrical contracting solutions. The company’s long-standing presence and positive reputation serve as an intangible but significant barrier to entry for newer competitors and provide a solid foundation for continued success in the Turkish market.
An Elite Performer History of Profitability
Since 2019, Orge Enerji’s revenue has compounded by 72.46% a year, a 5-year sales CAGR that places the company among the top 1.3% of companies globally. In the same period, its net operating profit after tax (NOPAT) has compounded by 97.39% a year, from ₺55.68 million to ₺1.69 billion, while its NOPAT margin widened from 39.56% to 48.66%, while its invested capital turns nearly doubled from 0.87 to 1.66. As a result, the company’s return on invested capital (ROIC) has more than doubled, from 31.58% to 81%.
Orge Enerji Still Has Upside
Despite a 25.96% share price appreciation in the year-to-date (YTD), the company remains attractively valued. At the current price, of ₺108.20 per share, Orge Enerji trades at an attractive price-to-economic book value (PEBV) of 1.32. This ratio implies that the market expects Orge Enerji’s NOPAT will increase by just 32% from current levels. I used my reverse discounted cash flow (DCF) model to tease out the expectations for future growth in cash flows implied by various scenarios for Orge Enerji.
In the first, I quantified the expectations implied by the current price, wherein:
Revenue compounds by the 3-year CAGR of 61.85%, its 3-year average, and,
NOPAT margin remains at 48.66%.
Orge Enerji is worth ₺116.73, an upside of 7.2%.
Impact of Footnotes Adjustments and Forensic Accounting
Here below are details of accounting adjustments made to Orge Enerji’s’ 2024 annual report:
Income Statement: I made ₺1 billion in adjustments to calculate NOPAT, with the net effect of adding ₺977.31 million in non-operating expenses. The adjustments are equal to 144.85% of Ogre Enerji’s IFRS net income.
Balance Sheet: I made ₺973.89 million in adjustments to calculate invested capital with a net decrease of ₺955.24 million. One of the largest of these adjustments was ₺73.53 million in excess cash, an adjustment worth 1.9% of reported assets.
Valuation: I made ₺964.46 million in adjustments with a net effect of decreasing shareholder value by ₺325.82 million. The largest of these adjustments was 577.28 million in net deferred tax liabilities, representing nearly 7% of Ogre Enerji’s market cap.
Companhia de Saneamento Básico do Estado de São Paulo – SABESP (BVMF:SBSP3: R$109.01/share), Brazil’s largest water and sanitation utility, serving 28.1 million people with clean water and 25.1 million with sanitation services in 375 municipalities in the state of São Paulo,, stands at the nexus of Brazil’s urgent infrastructure needs and an unprecedented wave of regulatory reform. Over nearly five decades it has operated as a publicly guaranteed regional monopoly, managing an R$ 80 billion asset base under long‑dated concessions, yet chronic underinvestment left service gaps, high water losses and mounting fiscal pressures on São Paulo’s state government. Privatisation has been the state’s answer to these problems, and with it an era of private‑sector discipline, enhanced governance and broader capital access. Traditionally, an investment that hinges upon an influx of capital is a thesis whose final outcome is shareholder value destruction, but the company’s existence as a monopoly whose essential profitability is protected, means that the investments-to-come will likely grow shareholder value, rather than destroy it, while achieving the state’s goals of universalisation of access to clean water and sanitation services. Management’s revamped incentive scheme and independent board, combined with a “strategic investor” privatization structure, have realigned leadership to profitability and service targets. Against a backdrop of rising sector margins, the country’s regulatory reforms and growing public-private partnerships (PPP) concessions nationwide set the stage for Sabesp to leverage scale, secure tenured assets until 2060 and navigate macro‑risks—be they tariff‑shielded inflation pass‑through or minimal exposure to trade‑war supply shocks. I believe Sabesp is a very attractive investment, whose economics, and a valuation that assumes a 36% decline in its core profitability, are hard to match.
The Road to Privatization
Privatization of Brazil’s water and sanitation sector began in 1996 under the government of Mr. Fernando Collor de Mello through the Programa Nacional de Desestatização, and by 2008, the private sector provided water for 4% of the country’s population. Today, ten of Brazil ‘s 26 states, São Paulo, Rio de Janeiro, Espírito Santo, Mato Grosso, Mato Grosso do Sul, Santa Catarina, Minas Gerais, Paraná, Pará and Amazonas, are now covered by 65 concessions contracts. Under concession contracts, the infrastructure is owned by the government and awarded by municipalities and states, but operated by concessionaries. This model has proven successful in expanding access to clean water and sanitation services. The private sector remains a small though growing player in water and sanitation, with private players such as AEGEA Saneamento e Participações S.A, enjoying higher-margins.
The drive toward privatization is a consequence of the need to address the infrastructure deficit the water and sanitation sector suffers. The government has attempted to spur added investment through legal mandates, most recently, the 2020 Sanitation Legal Framework (Law 14.026). The aim of this mandate is that, by March 2033, 99% of Brazil’s population will have access to drinking water, and 90% will have access to sewage collection and treatment services, a significant improvement from 2018, when, according to the National Sanitation Information System’s (SNIS), half of the population did not have access to sewage collection and treatment services and 16% did not have access to drinking water. This mandate envisages investments of around R$95 billion to achieve these twin goals, with a focus on underserved regions. Sector rules were standardised and private participation was incentivised through 30-year concessions and penalties for non-compliance. In the aftermath of the mandate, auctions surged, AEGEA, for instance, secured a R$15.2 billion contract in Pará state, demonstrating private appetite for long-term concessions.
Not only did the country witness a great demand for concessions, but, the Banco Nacional de Desenvolvimento Econômico e Social (BNDES) structured auctions and declared a financial capacity to finance as much as 80% of projects. For the 2019 to 2025 period, sanitation debentures are expected to reach R$43 billion, while multilateral institutions such as the International Finance Corporation (IFC) has also entered the fray, with João Carneiro, the IFC’s head of infrastructure investments, saying, “No other sector has a greater positive impact on society than sanitation.” The impact of this influx of capital will be to reduce the long-run cost of capital for concessionaires, an important point given high interest rates and residual regulatory uncertainty.
Sabesp, facing aging infrastructure with around 20% water loss due to leaks and underinvestment, long ago began the process of privatisation, but its operating structure, as a private-profit publicly guaranteed monopoly, proved a disincentive to investing in long-term infrastructure. During São Paulo’s 2014 Water Crisis, Messrs. Steffen Böhm and Rafael Kruter Flores explained that,
One of the world’s largest water utilities, Sabesp was founded as a public institution in 1973. Since part-privatisation in 1994 the state of São Paulo has maintained at least half of the company’s voting capital, though shares are also traded on the New York and São Paulo stock exchanges.While The Economist and others were keen to point out that Sabesp is “majority-owned by the state government”, this doesn’t tell the whole story. The utility is neither a public organisation concerned with providing a public service, nor a private company facing competition from other companies and controlled by regulatory agencies. Just like the “natural monopolies” enjoyed by water companies in the UK, Sabesp has a publicly guaranteed monopoly, yet its profits are part-privatised – earlier this year it paid out R$252m (US$83m) in dividends.
Sabesp pursued an alternative model to the private concession model in vogue, believing it a better way to resolve the incentive problems the previous model created. The company, like Companhia de Saneamento de Minas Gerais – COPASA MG (BVMF:CSMG3) in Minas Gerais and Companhia de Saneamento do Paraná – SANEPAR (BVMF:SAPR3) in Paraná, listed on the B3 S.A. – Brasil, Bolsa, Balcão. Sabesp is also listed on the New York Stock Exchange (NYSE). Sabesp also obtained loans from the Inter-American Development Bank and the Japan Bank for International Cooperation.
In 2019, São Paulo proposed to privatize Sabesp that very year in order to reduce fiscal burdens and align with federal pro-market reforms under President Jair Bolsonaro. Share prices rose 31% on privatization hopes. Privatisation, however, was only completed in July 2024 by the governor of São Paulo, Mr. Tarcísio de Freitas (Republicanos-SP). Under that agreement, São Paulo reduced its stake from 50.3% to 18.3%, while Equatorial Energia acquired 15% of Sabesp’s shares and became the new reference shareholder, and 17% of the shares were offered to minority shareholders, and another 40% of the shares are traded on B3 and 9.7% on the NYSE.
A Synergistic Relationship
Equatorial Energia, which owns power distribution companies in seven states, as well as a sanitation concession in Amapá, believes that its footprint in other states grants it the economies of scale and richness of expertise necessary to advance Sabesp’ expansion. According to Valor International, the firm’s focus is on improving Sabesp and its management, with the CEO, Mr. Augusto Miranda, envisaging a “long-term partnership”. Mr. Miranda believes that there are synergies between the two, given that not only is Equatorial Energia in energy and sanitation, but Sabesp itself not only serves 375 municipalities with water and sanitation services, it is also engaged in energy, paving and other sanitation-related services through six subsidiary companies:
Being a ‘multi-utility’ company is a differentiator – you’re already operating-, so these are complementary services, energy, and sanitation.
…
“We don’t need to grow for the sake of growth; we need to allocate resources efficiently.
In essence, what is promised is a blend of Equatorial Energia’s management model and Sabesp’s technical expertise. Noting that some municipalities in São Paulo are not covered by Sabesp, he said that,
If you look internally, there are municipalities that haven’t joined [the company] and are in neighboring areas. This is an opportunity. Sabesp’s reputation is an invitation for this.
New management, in place since October 1, 2024, and headed by CEO Mr. Carlos Leone Piani, who had previously served as chairman of Equatorial Energia, plans to invest R$70 billion by 2029 and R$260 billion by 2060 to fulfill its goal of achieving universal access to clean water and sanitation services. Piani is tasked with reducing the firm’s operating costs and optimally allocating capital without sacrificing service quality.
The company must abide by covenants which hold that at the end of every quarter, net debt/adjusted EBITDA must be lower than or equal to 3.50; and adjusted EBITDA/financial expenses must be equal to or higher than 1.5. Management expect to run at the limit of these restrictions, which are lower than other private-sector companies in the sector, with Equatorial Energia’s CFO, Mr. Leonardo Lucas, explaining that,
These are appropriate limits, especially in this interest rate environment. The company’s leverage is very low, and there is a significant opportunity to increase productivity. Additionally, the tariff review will be annual, so once the investment is made, there won’t be a long wait to receive the return.
An immediate benefit of privatisation is that, free from the shackles of state procurement policies, the firm will be able to act faster than it previously could.
Aligning Incentives
With privatization has come an additional lever for what Equatorial Energia’s CEO, Mr. Augusto Miranda calls, “engaging people”:
For example, Equatorial has a policy where there is a base salary, a medium-term salary with goals, and long-term incentives. With the company listed on the stock exchange, some people can even hold shares.
Although the role of reference shareholder lasts until 2029, the shareholder’s agreement can be renewed, which creates additional incentives for Equatorial Energia to deliver on its promises.
In tandem with the privatisation process, the company signed a new concession agreement with the Regional Unit of Drinking Water Supply and Sewage Services – URAE 1 – Southeast, covering 371 municipalities. It is in effect till 2060. Under this concession agreement ,the company is compensated based on its regulatory asset base, with annual tariff adjustments tied to how quickly the firm is accelerating its investments. In a field in which the firm faces no competition, this is a guarantee of profitability in the aftermath of the sought-out investments.
There are two five-year cycles whose asset base functions as a reference point for tariff adjustments: (i) 2024 to 2029 and (ii) 2030 to 2034. In the first, the goal is to achieve universalisation and quality improvement, for which significant investments are expected, enough to double the size of Sabesp’ regulatory asset base. All efficiencies with respect to the firm’s operating expenses are retained by it. In the second cycle, the goal is to improve operational efficiencies, for which there are loss reduction targets that will result in shared efficiencies with customers. The company will be remunerated based on the costs incurred and a predetermined weighted average cost of capital (WACC).
Tariff adjustments will, as aforementioned, be annual in the first two cycles, and quinquennial in the third cycle, subject to the company meeting universalisation and quality targets. The burden on customers is eased thanks to a Support Fund for the Universalization of Sanitation in the São Paulo State (FAUSP), which uses funds from Sabesp’ privatisation to keep tariffs at affordable rates, without hurting Sapesb’ profitability.
Improving Economic and Financial Performance
Even before these changes, Sabesp’ economic and financial performance was improving. The firm’s 5-year revenue CAGR for the 2019-2024 period was 14.98%, while its net operating profit after tax (NOPAT) compounded at a rate of 26.16%.
In that 2019-2024 period, Sabesp’s economic profit per share compounded from R$3.50 to R$11.47, at a rate of 26.79%, although the firm earned economic losses in 2021 and 2022, as its return on invested capital (ROIC) was lower than its WACC. At 23.2% in 2024, Sabesp’ ROIC is at its highest level ever.
In terms of operational efficiencies, it is noteworthy that Sabesp’ total operating costs and expenses as a share of total revenue, have fallen from 67.9% in 2019 to 55.94% in 2024, although the median value for the interim period was 77.11%. In other words, Sabesp was able to grow while keeping its operating costs under tight control.
Sabesp Is Priced for a 34% Decline in NOPAT
At its current price, Sabesp has a price-to-economic book value (PEBV) of 0.66, implying that the market expects its NOPAT to permanently fall by 34% from its 2024 levels. Using my reverse discounted cash flow (DCF) model, I teased out the expectations for future growth in cash flows implied by various scenarios for Sabesp.
In the first, I quantified the expectations implied by the current price, wherein:
NOPAT margin remains at its 2024 level of 39.98%, and,
Revenue declines by 20.55% in 2025, grows by 0.095% from 2025 onwards, in line with consensus estimates.
In this scenario, NOPAT falls to R$11.92 billion in 2028 -giving us a market-implied competitive advantage period (MICAP) of three years-, and the stock is worth R$110.93 today, approximately equal to the current price.
If, on the other hand, Sabesp’s
NOPAT margin falls to its 3 -year average of 24.49%, and
Revenue grows at 13.15% a year, it’s 3-year average, then,
the stock is worth R$123.69, an upside of 13.47% from the current price.
If, however, we assume that Sabesp’s
NOPAT margins remains at 39.98%, and
Revenue grows by its 5-year average of 14.98%, then,
the stock is worth R$255.69, a 135% upside from the current price.
Impact of Accounting Adjustments
I made numerous accounting adjustments to Sapesp’ 2024 financial statements, with the following impact:
Income Statement: I made R$4.87 billion in adjustments to calculate NOPAT, with the net effect of adding R$4.87 billion in non-operating expenses. The adjustments are equal to 50.84% of Sabesp’s IFRS net income.
Balance Sheet: I made R$11.54 billion in adjustments to calculate invested capital with a net decrease of R$11.07 billion. One of the largest of these adjustments was R$4.66 billion in excess cash, an adjustment which, on its own, is worth 5.75% of reported assets.
Valuation: I made R$32.58 billion in adjustments with the net effect of reducing shareholder value by R$23.26 billion. The largest of these adjustments was R$25.26 billion in adjusted total debt, representing 33.9% of Sabesp’ market cap.
Just before I had a chance to take a position on ProShares Ultra VIX Short-Term Futures ETF (UVXY) for the second time, President Donald Trump announced a 90-day pause on additional tariffs, and the market flirted with euphoria for a day. The president then went on to announce exemptions for various consumer electronics from the U.S. tariffs on China. However, the arguments made in my second thesis, and my first, which gained 34% in just a few days, are still valid. I expect to redeploy the UVXY and adding on to that, the 2x Long VIX Futures ETF (UVIX), as a riposte to the current disruptive phase of radical uncertainty. This will happen when I think it is, basically, a no brainer. Till then, I thought I would go over my thinking.
UVIX and UVXY Overview
Both the UVIX and UVXY offer leveraged exposure to VIX futures. While UVXY generally aims for 1.5× daily performance of short-term VIX futures, UVIX targets a higher multiple. These instruments are designed to profit in a volatility spike; however, their daily rebalancing and contango roll costs usually induce a decay when held in a low-volatility or mean-reverting environment. In a regime of high and sustained volatility, these products can track, and even magnify, the downward volatility surge. This is a key empirical observation behind using volatility ETFs as tactical tools during periods of systemic stress.
A feature of capitalism is inherent in its name: the accumulation of capital, which has the effect of reducing the cost of capital. For example, a paper by the Bank of England found that in the last eight centuries, interest rates have been heading toward zero. With this comes an easing of volatility. Today’s investor is far more protected against the slings and arrows of outrageous fortune than a merchant sending ships out to trade a millennium ago. What this means is that instruments like the UVIX and UVXY do not tend, in the modern world, to be good buy-and-hold instruments. As capital accumulates, it demands to be invested, and that bids up the price of assets. The S&P 500 will never fall to the price it was in 1871 or even 2000. So, if you held the UVIX or UVXY from their inception in 2022 and 2011, respectively, to date, one would have lost all one’s money.
In an age of radical uncertainty, time is accelerated. This has profound implications for investors: one of the features of risk is that wealth, in the long run, tends toward its own destruction. Under uncertainty, wealth destruction happens much faster, and downside volatility is more pronounced. In the long run, investing in stocks -or more correctly, in stock market indices-, is by far the best investment that anyone can make, but there are periods in history where stocks underperform other assets.
There have been periods in which betting on the downside has proven profitable. The CBOE Volatility Index’ (^VIX) best periods have been the current moment, during the Covid-19 stock market crash and the Great Recession of 2008. There is no data pre-1990, but I imagine that the crash of 1987 and the Great Depression would be other analogies. In these periods, volatility indices or products based on VIX futures surged while broad equity indices suffered significant declines. In the last year, the UVXY has gained 21.9% compared to just over 2% for the SPDR S&P 500 ETF (SPY). That is not supposed to happen. According to Fidelity,
There is wide variation for how long volatility tends to last, but one thing’s for sure: Volatility is common. Since 1980, the S&P 500 has experienced a drop of 5% or more in 93% of calendar years. Despite those frequent declines, the market’s average calendar-year return over the same period has been more than 13%.
There have been many bouts of volatility that haven’t led to steep declines, though at times it has. Research shows corrections (generally considered a decline of 10% from recent highs) have lasted an average of 115 days and bear markets (at least a 20% decline) have lasted a median of 19 months.
The UVXY is designed for short-term, tactical attacks on the stock market; it is not supposed to be a buy-and-hold instrument, and certainly not the sort of thing one holds for an entire year. In the year-to-date (YTD), the UVXY is up 101.7%, and the UVIX is up 106%, while the SPY is down 10.5%. I do not know of a single investor who can match those numbers. My contention is that, in an age of uncertainty, the stock market has become dangerous.
The Market Expects Relative Calm
The S&P 500’s 30-day implied volatility (30-day) is currently 0.3522, compared to a historical volatility for the same period of 0.4922. This gulf has been present for some time and illustrates that the market’s current options pricing is forecasting that future volatility over the next 30 days will be lower than what was realized over the past 30 days. Implied volatility is derived from option prices and reflects the market’s consensus of how volatile the S&P 500 will be in the future. An implied volatility of 0.3522 suggests that, based on current option premiums, market participants expect the asset’s returns to fluctuate at an annualized rate of about 35.22% over the next month. Historical Volatility is calculated from past price data, and shows what the asset’s volatility has been recently. A historical volatility of 0.4922 indicates that over the past month, the asset’s returns have fluctuated at an annualized rate of roughly 49.22%. In essence, the market is priced for greater calm and views the high historical volatility as an anomaly or as the consequence of short-term factors that are not expected to persist.
The market value of the S&P 500 is not an objective fact that market participants merely react to, it is shaped by market participants and their views in what George Soros referred to as “reflexivity”, in his book, “The Alchemy of Finance”. Despite their brief flirtation with euphoria, the Keynesian “animal spirits” are perceiving an increasingly unattractive U.S. stock market, and even U.S. Treasuries have suffered. In this market, the U.S.’s Magnificent Seven have been outperformed by China’s Seven Titans. Having underestimated market risks for so long, investors have still to grapple with the risks inherent in the U.S. stock market, as seen by their day of euphoria. A hidden vulnerability is now becoming visible, making instruments such as the UVIX and UVXY attractive for hedging or speculative gain. Investor sentiment is bearish, and this will shape markets. Euphoric highs need euphoric sentiments and sentiments right now are pessimistic. The AAII Investor Sentiment finds that this week, 58.9% of investors are bearish. In the year ending April 2, 2025, bearish investor sentiment infected 61.9% of investors surveyed. It is noteworthy that the last bullish high was in the year ended July 17, 2024 and that the historic average for bearish sentiment is 31%. BlackRock, the world’s largest asset manager, has already started reporting a slow-down of inflows, as a consequence of growing investor pessimism. This can be seen with how quickly the market’s euphoric response to the president’s announcement of 90-day pause to additional tariffs faded. One of the oddities of that response is that stocks that are clearly harmed by tariffs on China -which are now effectively 145%-, went up by over 10%, with the Magnificent Seven tech stocks regaining $1.8 trillion in market value, a one-day record in which NVIDIA (NVDA) rose 19%, Tesla (TSL) shot up 23%, and Apple (AAPL), and Meta Platforms (META) –whom I have written about– added 15%. This was before the president announced his carve-out for consumer electronics. Not only did the then-current tariff position leave the Magnificent Seven weaker, it also compelled a downward re-rating of the S&P 500. The day after that euphoric response, markets slumped, and the UVXY and UVIX once again triumphed.
In uncertain environments, investor sentiment can swing widely. I abandoned my attempt to enter this position for a second time because I believed that the losses would be huge. I think the UVXY was down around 36%, which would have meant I would need a 55% bounce to get back to where I started. However, I could have entered it regardless, because in an environment of wildly changing investor sentiment, it is easy to make up such losses, as latent overconfidence gives way to panic or massive downward re-pricing. Regime uncertainty will cause extreme movements in volatility, again justifying a bet on VIX-linked instruments.
Causes for Sustained Downward Volatility
The Aggregate Investor is Overinvested in Stocks
In some ways, this period of intense downward volatility was predictable. Even without tariffs, portfolio allocation was already too heavily tilted toward stocks. An era of prolonged wealth accumulation and stability led to progressively riskier portfolio allocations until the U.S. aggregate investor reached historic levels of equities-allocation. If the previous period of low-volatility and easy wealth accumulation has led to a widespread underestimation of risk, a “Minsky moment” of sorts is plausible, leading to a sudden surge in volatility. In the first and second theses, I pointed out that, using a measure I call, “equity preference”, as of the end of Q4 2024, the aggregate investor’s portfolio was 52.18% allocated to stocks, the highest level since the Fed started collecting the component data in Q4 1945. If equity preference refers to the demand for future 10-year returns, and those returns are relatively inelastic, then, as equity preference rises, the price of those future returns rises, even as their supply declines. A regression analysis I did last year, pre-Q4 2024, when equity preference rose slightly, pointed to 10-year returns of around 1% a year. So even before the new tariffs were put in place, investors had rational reasons to exit the S&P 500. An equity reference of around 45% is probably needed to allow investors to gain 5% plus returns per year over the next decade. That means an enormous exit of capital, and a fall in the price of stocks.
Regime Uncertainty
We are in a revolutionary moment that suggests that a prolonged bout of elevated downward volatility may be emerging due to systemic pressures, accumulated risk, and macroeconomic imbalances. Perhaps controversially, in the second thesis on UVXY, I argued that, regardless of one’s opinion on tariffs, the Trump Admin. has powerful motives for supporting them:
The China Shock has gutted the manufacturing industries of countries across the world, such that, despite the broad wealth created, working class people have been left behind, stoking populist outrage. Such a system is unsustainable.
In a military contest with China, the economic benefits of a global division of labour pale beside the risks of relying on a trade partner that builds the things that America will need to wage war.
From the perspective of economic competition, the current division of labour is not static, and China can use it to achieve parity with the U.S. in those areas in which the U.S. is currently a world leader. BYD’s stunning success is an example of this.
I stressed that it really does not matter if one agrees with the administration’s motives, just that they are powerful enough that one should not expect tariffs to end completely. At a minimum, tariffs on China are likely to stay, even under a Democratic administration, all that is to be decided is the size of those tariffs. The Magnificent Seven, the most profitable businesses in human history, are a third of the S&P 500. Tariffs will erode their profitability and force investors to look elsewhere for investments, and that “elsewhere” will not benefit from the same premiums-to-value that the Magnificent Seven does, and that implies a downward revision in the price of the S&P 500.
There was another obvious wrinkle:
There are two tiers of tariffs, with 30 countries having special tariffs, and the rest of the world having a flat 10% tariff, while Canada and Mexico can be said to belong to a third tier whose tariffs were negotiated earlier. Although the U.S. successfully used tariffs to force reforms in Japan in the 1980s and 1990s, tariffing the globe presents obvious problems. First, trade negotiations take time, they are not something that can be finished in a few weeks or a month. The Peterson Institute for Economics found that the U.S. takes an average of one and a half years to negotiate and sign a bilateral trade deal, and three and a half years to get to the implementation stage. Jordan has been the quickest off the mark, taking four months to get a free trade deal with the U.S. and eighteen months to get to the implementation stage, while the free trade deal with Panama took thirty-eight months to negotiate and one hundred and two to get to the negotiating stage. Negotiating thirty to nearly two hundred trade deals within a one-to-two year window, especially with a government reduced in size, seems very challenging to me. Key trade partners such as Japan may be given priority, but this would still leave many countries without a trade deal or even the beginnings of a negotiation, for some time.
Trade wars similarly take time, and this is important with regards to China. To get a base rate for how long trade wars take, I used a list of important trade wars from Wikipedia’s page on the subject. In the pre-modern era, the average length was 222 years, with a sample size of just 5. In the twentieth century, the average length was 19.7 years, with a sample size of just 7. In the 21st century, the average length is 12.6 years, with a sample size of 23. The current U.S.-China trade war has been going on since 2018, without meaningful resolution. When I looked at trade wars from the post-Second World War era involving more than five countries, I found the Chicken Wars in the 60s, which lasted 6 years, the beef hormone controversy which lasted 19 years, the Tuna-Dolphin case that lasted 50 years and the Trump-era trade wars that have been going on for 7 years. Simply, trade wars seldom fade out very quickly, largely because negotiations are protracted and each side sees it as being of such strategic importance to win that a collapse of one counterparty to the other’s terms is highly unlikely.
Consequently, the best case scenario is that definitive trade deals will only emerge within the next two years and that whatever is agreed now will be provisional and therefore changeable.
What this means is that there will be no substantive trade deals within 90-days. Like the TikTok deal, these trade deals will require an extension. Tariffs alone destroy both demand and supply, and the resulting attenuated regime uncertainty is an additional cost of doing business, a dis-incentive to invest that will hurt the stock market and the broader economy. I think those in favour of tariffs and those opposed to them are both united in accepting that there will be pain on the road to the final outcome. Regime uncertainty is an idea developed by Robert Higgs to understand how economic agents respond to profound changes in the economic regime, and his work found that investors adopt a “wait and see” approach, lest the rules of the game change again. The only way the president can quicken the pace is by dropping blanket tariffs and substituting them with more focused sector/product tariffs, but even doing that will likely take at least six months to a year, and with 75 or so trade deals to negotiate, it is likely that the U.S. will make mistakes that compel them to demand a renegotiation of some terms. The Wall Street Journal (WSJ) makes a similar point, explaining that the Trump Administration is racing to strike ad hoc trade deals with over 70 countries, while warning that any agreements are “likely to fall short of the kind of fully-fledged trade pacts that traditionally shape global trade.” The WSJ goes on to say that,
Traditional free-trade agreements typically take several years to negotiate. Narrower deals covering specific industries that Trump reached with nations such as China, Japan and Korea in his first term took several months. The White House now needs to speed-run negotiations much faster and with dozens of nations at the same time—something that is worrying lawmakers on Capitol Hill who are eager to see deals reached that can avoid the tariff-induced stock selloff of the past week.
The deals aren’t likely to be fully developed free-trade agreements, which typically need to be passed by Congress. Instead, Sen. Bill Hagerty (R., Tenn.), Trump’s first-term ambassador to Japan, said the administration might settle for written commitments from foreign governments to make certain economic reforms, akin to a term sheet that precedes an investment or business deal. That perspective was backed up by a foreign-government official in contact with the U.S.
Sen. Bill Hagerty (R., Tenn.), who served as Trump’s first-term ambassador to Japan, believes, at least according to the WSJ, that these 90 days will only result in the parameters of a deal. National Economic Council Chairman Kevin Hassett added that countries would need to offer “some kind of extraordinary deal to go below” the 10% base tariff. tariffs are here to stay.
The combination of the government’s need for tariffs to compete with China and other hostile actors, and to reform the system, and the pressure to do this by the mid-terms, is such that, although the president faces market pressure, he also faces a pressure to deliver. Research shows that, whatever the public believes about politicians,politicians tend to try and do what they campaigned on. The revolution is not over.
This thesis, which also appeared on SumZero, became un-actionable within moments of my writing it up, as President Donald Trump announced a 90-day pause on additional tariffs, which meant markets would go up. However, the crux of the thesis remains correct: 10% tariffs remain and tariffs on China have gone up to 125%, validating my argument that tariffs are, at least for the next 90 days, here to stay and that a trade war with China would be the hardest to de-escalate. Oddly, Apple (AAPL), NVIDIA (NVDA), Meta Platforms (META) and other Big Tech firms that are obviously hurt by tariffs on China, all went up by over-10%, suggesting that the market has not properly digested the tariffs situation. Overall, the UVXY proved my best idea to date, with a gain of over 34% in just days.
As I was I researching for my masters thesis on “The Nature of Risk”, the basis for my PhD -when it commences-, I came to have a rather curmudgeonly reaction to phrases like, “upside risk”, or people quoting Warren Buffett”s, “be greedy when others are fearful, and fearful when others are greedy” remark. “Upside risk” does not exist, risk is always and only the downside. As for greed in times of fear, even Buffett sold his airline stocks during the Covid-19 crash, and he has not yet sashayed into the markets, because there is a magnitude of price decline so large that it is, in and of itself, a risk for the holder of a stock and in this revolutionary moment, even a very attractive stock could be decimated on the stock market before an investor sees any positive returns. On Tuesday, I fell for an absurdity. I closed my four-day old position on ProShares Ultra VIX Short-Term Futures ETF (UVXY), certain that markets had duly considered the obvious reality that China would not scale back their counter-tariffs and that this trade war will be long-lasting. I expected a period of calm and the market duly responded with alarm. It was as if I had tacitly admitted to the strong version of the efficient markets hypothesis. That was incredibly silly. My apologia aside, I am reinitiating my position. I will attempt to do three things in this rather long essay: explain why, from a political and then a historic point of view, this period of uncertainty will be elongated, show why investors have rational reasons to reallocate capital away from the stock market regardless of tariffs, and then, why I think the UVXY will do well for longer than usual. The nature of the argument will be novel to analysts who are used to not having to think about politics first and factor in the possibility of years of uncertainty, so my arguments will be fuller than normal, but I think worthwhile. However, such is the ontology of these changes that developed world analysts have to embrace tools more familiar with analysts from the emerging world, and think about the political and historic before making an investment decision.
Tariffs are Strategically Important to the Trump Administration
In discussions with various people, I have been struck by the feeling that this will all be over in a few weeks. When I have suggested a one to two year timeframe, I have faced pushback. Markets seem to be behaving in a similar fashion. There seems to be a failure to treat the Trump Administration’s policies seriously, which has led to a lot of wishful thinking of the, “If markets keep falling, tariffs will have to be abandoned” sort. This is a mistake: as a rule, when a government believes that a goal is of supreme strategic importance, it is willing to incur the maximum possible economic pain to achieve that goal. When Vladimir Putin invaded Russia, he did not back down when Russia was hit with sanctions, because stopping Ukraine’s drift Westwards was that important to him. In my country, Zimbabwe, between 1997 and 2000, the government enacted a series of measures, including forcible and often violent expropriations of land owned by white farmers, that turned a fairly prosperous country into one whose economy halved in size within a decade, and which, even today, is such that a person living in 1950’s Rhodesia (colonial-era Zimbabwe) was better off than a Zimbabwean living today. Those policies have never been reversed because the government is convinced about their strategic importance. In this section, I will attempt to explain why I believe there is no near-term reversal on tariffs, at least with regards to China.
Now, this is not an assessment of the Trump Administration’s efforts. The arguments against tariffs are widely known, and although I think the odds are against their success, there are arguments in favour of them. That, however, is beside the point, my thesis is that these actions are revolutionary, regardless of their outcome, and that they create such uncertainty that investors will feel rationally obliged to dump stocks, U.S. stocks in particular, and, because there are so many shocks ahead, we are in a unique moment in which betting on the UVXY outperforming the S&P 500 over sustained periods of time, is possibly the best investment that anyone can make.
In an article for FRPI, “Obscurity by Design: Competing Priorities for America’s China Policy”, Tanner Greer gives a taxonomy of the Trump world that I think provides a good way to understand the reasons why the Trump Administration will be able to go the distance on tariffs. My reading of this is that there are three major reasons why tariffs matter to the Trump Administration:
First, although globalisation has been undeniably successful in making the world, and the United States, richer, the China Shock, has gutted the manufacturing industries of countries across the globe, and although the proportion of people affected may be relatively small, the social consequences are such that if the concerns of workers are not addressed, the conditions for revolution are created. Again, Zimbabwe provides an interesting analogy: while the country largely prospered between the 1960s and the mid-1990s -at one time richer than Singapore and Luxembourg-, a proportion of workers and peasants were left behind, and this, coupled with the failure to resolve the land issue, resulted in a social movement to retake white-owned land. In a country of 15 million people today, those involved numbered just 1% of the country. A system is unsustainable if it systematically leaves people behind.
Second, if China and the United States ever go to war, the United States is at a manufacturing disadvantage and would essentially have to relearn how to “build things” during such a war. Greer explains this view saying, “If past wars pattern future ones, great power conflict means that both parties will stretch their industrial capacity to its limit. In that day of woe, outmoded industries will matter. Whether a country can smelt steel, refine rare earths, and build ships will decide death or survival. “It is foolish,” one Trump official tells me, “to imagine that the external sources of these goods will not be disrupted or interdicted in a time of global war.” The time to prepare for that possibility is now.”
Third, the classic idea of a division of labour is too static and policy needs to be more alive to the fact that a peer competitor such as China can move from manufacturing to services, competing directly with the United States. Greer observes that,
The first is that winning blue-chip firms do not emerge out of a vacuum. Technological revolutions often require an entire “industrial commons” with crosslinked supply chains and shared talent pools. As Oren Cass, the intellectual don of these quadrants, puts it: “Industrial expertise is not something bought off the shelf, it comes embedded deep within an ecosystem of relationships between educational institutions and firms; experienced workers and new hires; and researchers, engineers, and technicians. What a nation can make efficiently tomorrow depends heavily on what it makes today, which is one reason why saying it doesn’t matter what we make in America is so wrong-headed.” Many of these ideas are grounded in a close study of China’s economic model. It is common for Chinese firms to pivot from one industry to another. Phone companies become electric battery companies; car companies build semiconductor fabs; software companies start to manufacture drones. This is easy for these Chinese firms to do because each belongs to a group of interlocking industries that share skilled labor pools, domestic suppliers, and industrial know-how. In other words, if China has an advantage in manufacturing solar panels and electric vehicles, it is because they first had an advantage in manufacturing liquid-crystal display screens and iPhones. Those who advocate for a manufacturing renaissance argue that what is true of China will also hold true in the United States.
This framing is true not just of China, but of the United States’ major trading partners. Ben Thompson of the marvellous Stratechery blog, said in an article, “Trade, Tariffs, and Tech”,
What I do come back to, however, is what I opened with: there is a scenario within the realm of possibilities that is far more painful than anything Trump proposed; is it better to try and force into place a new economic system that, at least in theory, reduces dependency on China and resuscitates U.S. manufacturing now, instead of waiting for the current system to collapse by literal force? This does seem to be the administration’s goal: simply tariffing China is deadweight loss, leading to rerouting and the fundamental problem of the dollar as reserve currency unaddressed; blanket tariffs, on the other hand, are a valid, if extremely blunt and inefficient, way to meaningfully restructure incentives.
Moreover, even if an invasion never happens, is the current system sustainable, fiscally or societally? Trump’s political success is, in many respects, the clearest manifestation of what happens in a system that pushes the gains to the globalized top while buying off the localized masses with cheap trinkets.”
Global capitalism is the greatest economic experiment of all time. Even Karl Marx recognised its merits, saying in “The Communist Manifesto”, that,
The bourgeoisie, during its rule of scarce one hundred years, has created more massive and more colossal productive forces than have all preceding generations together. Subjection of Nature’s forces to man, machinery, application of chemistry to industry and agriculture, steam- navigation, railways, electric telegraphs, clearing of whole continents for cultivation, canalisation of rivers, whole populations conjured out of the ground – what earlier century had even a presentiment that such productive forces slumbered in the lap of social labour?
Yet, capitalism’s discontents have created revolutionary moments and outright revolutions since it first emerged. The problem for the investor today is not whether or not Trump’s tariff formula is wrong or whether this will lead to the Great Depression, but that these policies are of strategic importance to the Trump Administration and that any change of course will only happen if there are clear signs that the real economy is suffering and that Republicans are headed to electoral wipeout in the midterms.
Tariff Deals and Trade Wars Take Time
There are signs that the U.S.’s leverage is working. Treasury Secretary Scott Bessent has said that more than fifty countries have approached the U.S. for a deal. The European Union’s (EU) president, Ursula von der Leyden, has,
offered zero-for-zero tariffs for industrial goods …Because Europe is always ready for a good deal. So we keep it on the table. But we are also prepared to respond through countermeasures and defend our interests. And in addition, we will also protect ourselves against indirect effects through trade diversion. For this purpose, we will set up an ‘Import Surveillance Task Force’. We will work with industry to make sure we have the necessary evidence base for our policy measures. We will stay in very close contact to minimise effects of our actions on each other.
The EU’s counter-measures are likely to be less forceful than predicted, but more targeted, with a seeming goal of inflicting maximum pain on red states. However, there are banal reasons why tariffs, even if the administration does not see them as permanent measures but as negotiating tools, will remain for some time.
There are two tiers of tariffs, with 30 countries having special tariffs, and the rest of the world having a flat 10% tariff, while Canada and Mexico can be said to belong to a third tier whose tariffs were negotiated earlier. Although the U.S. successfully used tariffs to force reforms in Japan in the 1980s and 1990s, tariffing the globe presents obvious problems. First, trade negotiations take time, they are not something that can be finished in a few weeks or a month. The Peterson Institute for Economics found that the U.S. takes an average of one and a half years to negotiate and sign a bilateral trade deal, and three and a half years to get to the implementation stage. Jordan has been the quickest off the mark, taking four months to get a free trade deal with the U.S. and eighteen months to get to the implementation stage, while the free trade deal with Panama took thirty-eight months to negotiate and one hundred and two to get to the negotiating stage. Negotiating thirty to nearly two hundred trade deals within a one-to-two year window, especially with a government reduced in size, seems very challenging to me. Key trade partners such as Japan may be given priority, but this would still leave many countries without a trade deal or even the beginnings of a negotiation, for some time.
Trade wars similarly take time, and this is important with regards to China. To get a base rate for how long trade wars take, I used a list of important trade wars from Wikipedia’s page on the subject. In the pre-modern era, the average length was 222 years, with a sample size of just 5. In the twentieth century, the average length was 19.7 years, with a sample size of just 7. In the 21st century, the average length is 12.6 years, with a sample size of 23. The current U.S.-China trade war has been going on since 2018, without meaningful resolution. When I looked at trade wars from the post-Second World War era involving more than five countries, I found the Chicken Wars in the 60s, which lasted 6 years, the beef hormone controversy which lasted 19 years, the Tuna-Dolphin case that lasted 50 years and the Trump-era trade wars that have been going on for 7 years. Simply, trade wars seldom fade out very quickly, largely because negotiations are protracted and each side sees it as being of such strategic importance to win that a collapse of one counterparty to the other’s terms is highly unlikely.
Consequently, the best case scenario is that definitive trade deals will only emerge within the next two years and that whatever is agreed now will be provisional and therefore changeable. China under President Xi Jinping, long anticipated a need to create a world in which it was less dependent on the U.S. In fact, China’s Great Firewall, which predates Xi, is, perhaps, the greatest example of the success of protectionist policies, leaving China as the only country in the world with analogues to the U.S.’s Big Tech. Xi has broadened and accelerated that attempt to create structures outside U.S. control and influence, and the irony of Russia’s invasion of Ukraine is that it alerted China to how profound its weaknesses were and how sharply they would be exploited, if it entered into conflict with the West. Since President Donald Trump’s first administration, China has assiduously prepared for a heightening of tensions. Today, China feels itself uniquely prepared for this moment. The Economist noted that, not only does Xi not have the space to push through the changes Trump wants, they now believe that they can win a trade war:
Chinese officials may also believe that America will be unable to bear the inflation and economic discontent caused by Mr Trump’s tariffs. Instead of “fighting to the end”, they may only need to fight until American consumer prices begin to rise or employment begins to fall. Senior advisers, government researchers and economists all point to this as the easiest way of bringing Mr Trump to the table. Some talk of finding ways to exacerbate the situation, perhaps by strengthening the yuan. This would be quite a gamble. By the time inflation had picked up in America, Chinese industry and supply chains would be suffering.
An escalating trade war means that Xi Jinping will need to do more to prop up China’s economy. The potential shock is being compared to the global financial crisis of 2007-09, which elicited a stimulus package of 4trn yuan ($590bn). Li Qiang, Mr Xi’s deputy, said in March that the country was preparing for “bigger-than-expected external shocks” and that it was willing to enact policies to ensure economic stability. What this means in practice remains unclear. The People’s Daily, a state newspaper, said on April 6th that cuts to interest rates and banking-reserve ratios could come at any time. The paper has also said that local governments will help struggling exporters to find new sources of demand at home and in non-American markets. Soochow Securities, a Chinese broker, has suggested that China could lower tariffs on the rest of the world, while increasing export subsidies.
All this leads to the midterms. By then, Trump will be hoping to have a series of comprehensive trade victories to announce with a lifting of economic pain, while Xi will be hoping that the pain visited upon the U.S. will be such that Trump will be forced to climb down from his demands in order to save Republicans in the midterms. None of this suggests a quick resolution.
Equity Preference Gives Investors Rational Reasons to Reallocate Capital Away from Stocks
A final argument for prolonged stock market mayhem is that, using a measure I call, “equity preference”, which was first developed by the pseudonymously named Jesse Livermore of the Philosophical Economics blog, I determined that, as of the end of Q4 2024, the aggregate U.S. investor had allocated 52.18% of their portfolio to equities, the highest level since the Fed started collecting the component data in Q1 1951. Equity preference is, in essence, a measure of demand for future returns, returns which are relatively inelastic, which is to say, they are less changeable than demand. Ceteris paribus, if supply is relatively fixed, while demand rises, then the price of a thing, in this case, future returns, will rise, even as the supply of that thing declines. Equity preference tells us that future 10-year S&P 500 returns are inversely correlated with equity preference. At current levels, the S&P 500 was already headed to a decade of returns of around 1% a year. An investor who bought the market in Q4 2024 and holds for the decade after, will likely do worse than an investor who buys U.S. Treasuries.
Investors will recognise the truth of this once they concede that the highest returns usually come at the bottom of a bear market, not the top. Or, to use a quote often erroneously attributed to Nathan Rothschild, “the time to buy is when there’s blood in the streets.” Investors have increasingly bought when the streets have been laden with gold. As investors re-examine their portfolios, they will be forced to exit the stock market, and have already done so at record dollar amounts, because the prospective returns are so low. Equity preference would have to fall to something like 45% for the stock market as a whole to be more attractive.
While individual stocks and certain sectors may do well, overall returns will be poor. So even if tariffs magically disappeared tomorrow, investors have started to lose their optimism, and that is not a great formula for a sustained bull market.
Downside Volatility Will Be Sustained
The UVXY is typically used for very short periods. It is, at base, a bet that the market will go down. Typically, this is such an improbable event that, if one held the UVXY from inception to date, one would have lost all one’s money. However, it is the very best instrument out them for profiting on sustained downside volatility. In my initial essay, I said that,
While I suspect that this crash will end up greater than the Covid-19 crash, one can use it as a way of benchmarking expectations. Between March 1 and April 1 2020, the S&P 500 slumped some 16.4%, compared to a rise of 187.7% for the UVXY.
When the UVXY first entered the market October 31 2011, in the wake of the August 2011 stock markets fall, the S&P 500 fell 4.64%, while it gained 21.75%, between October 31 and November 29.
The final analogy is indirect: during the 2008 financial crisis, specifically between 1 August 2008 and 30 July 2009, the CBOE Volatility Index (^VIX) gained 27.6%, while the S&P 500 declined 28.3%.
These are the results of a simple buy-and-hold strategy of an instrument that is typically deployed for very short periods. The results are even greater when the VIX is deployed for shorter periods, before decay sets in as the market recovers. At a base value, I expect to gain 20% over the next month from the UVXY, and higher than that in short bursts.
The combination of the uncertainty created by a set of novel economic policies that defy the median investor’s expectations, and the high equity preference levels, both at the same time, compel investors to exit markets and to do so over prolonged periods of time, with sometimes a glut of sales happening has investors process new information that seems to confirm their worst imaginings. Like the Nixon Shock, it may turn out that this revolution was inspired, but despite the immediate popularity of the measures, with the Dow Jones Industrial Average ((DJIA) going up 33 points the day after the Nixon Shock policies were announced, the aftermath, at least in terms of the stock market, was terrible. It is only in the long run that it has been seen as necessary and brilliant. As this rearrangement of the global economic order is occurring, investors will struggle to answer basic questions, and will retreat to safety. As that is happening, downside volatility will rise, and along with it, the UVXY. At base, I expect that the worst of this will occur in the next three or so weeks, after which, the worst of the downside volatility will be behind us.
Such is the importance of novelty of these conditions that I think that the UVXY will, at a minimum, return to its August 5 height of $61.77 per share, and I am setting that as a target, although, if you believe as I do that this is the greatest series of economic changes in a century, then $61.77 will not only be easily reachable, but will be far surpassed.
Conclusion
Hopefully, I have succeeded in explaining why the Trump Administration is unlikely to lay down arms in the near-term, why even if trade talks are opened today, their ultimate conclusion and the shape of the new economic order is at least a year away, why equity preference levels provide investors with additional reasons to exit the U.S. stock market, and why this combination of factors means that investors should expect prolonged downside volatility. This is true regardless of the final outcome, whether it is the Great Depression Redux or a post-Nixon Shock Prosperity. When investors do not have analytical clarity and that persists for a long time, downside volatility reigns. In such an environment, the most direct way to benefit is an instrument such as the UVXY. I have joked with various friends that, short of Bank of Japan-style direct acquisitions of stocks, I do not think that the Fed has enough tools to bail out the stock market and with inflation a concern, that would be a bizarre turn. Downside volatility will define the market for the next few weeks, at least.
Daniel Bernoulli’s paper, “Exposition of a New Theory on the Measurement of Risk” is, perhaps, the greatest theory of risk ever told. First published in Latin in 1738 in the Papers of the Papers of the Imperial Academy of Sciences in Petersburg, it was only translated into English in 1954, its importance such that this translation was published in Econometrica, one of the great journals of the economics discipline. This paper is the basis of my investment philosophy, and has guided some of the greatest investors of all time, notably, the recently late Jim Simons of Renaissance Technologies, and Warren Buffett -although I think that Buffett at least is unaware of this lineage-. This is, above all, a theory that assumes that wealth, in the long run, as I have previously said, is destroyed, that investors are in a perpetual duel with catastrophe.
Portrait of Daniel Bernoulli, c.1720-1725, Basel Historical Museum.
The Problem of Points
Expected value, the probability-weighted average of possible payouts, has been the dominant decision criterion since the seventeenth century. Its genealogy can be traced back to mathematicians’ first attempts to develop a solution to the problem of points. The problem of points occurs when two players, with equal chances of winning future rounds, and who contribute equal amounts to winnings, and agree that the winner of a predetermined number of rounds will win the game, are forced to abandon their game before that predetermined number. Those players are then faced with a dilemma: how to divide the stakes fairly.
The monk Luca Pacioli’s book, Summa de arithmetica, geometrica, proportioni et proportionalità, written in 1494, proposed one of the earliest resolutions to the problem of points. Yet, he, along with other luminaries of the world of Renaissance mathematics, such as Niccolò Tartaglia and Giovan Francesco Peverone could not grasp upon a convincing solution. In my unpublished master’s thesis1, I observed that,
Tartaglia so despaired of finding a solution that he declared that any solution was “judicial rather than mathematical”, and would be so contestable as to lead to litigation.
The Birth of Expected Value Theory
In the late summer of 1654, Antoine Gombaud, known as the Chevalier de Méré, presented the problem to Blaise Pascal. In my thesis I noted that,
Pascal presented his solution to Pierre de Fermat, stating that he had discovered a way to calculate a fair division of stakes, later providing his complete solution in his book, Traité du triangle arithmétique avec quelques autres petits traitez sur la mesme matière. The correspondence between the two mathematicians, in which they developed three solutions to the problem, reveals that they understood as a fundamental principle that a fair division of stakes had to reflect the chance of getting it.
Having seen Pascal’s (1665) solution, Christiaan Huygens’ book, De Ratiociniis in Ludo examined the problem of points and presented Pascal’s expectations-based solution to the world in the world’s first systematic treatise on the mathematical theory of probability. More than a millennia since Aristotle had laid the foundations of a mathematical theory of probability, one had finally emerged. Huygens established the notion of expected value, saying,
“That any one Chance or Expectation to win any thing is worth just such a Sum, as wou’d procure in the same Chance and Expectation at a fair Lay. As for Example, if any one shou’d put 3 Shillings in one Hand, without telling me know which, and 7 in the other, and give me Choice of either of them; I say, it is the same thing as if he shou’d give me 5 Shillings; because with 5 Shillings I can, at a fair Lay, procure the same even Chance or Expectation to win 3 or 7 Shillings.”
In essence, one is faced with two outcomes:
Outcome 1: Win 3 shillings, with a probability of 50%
Outcome 2: Win 7 shillings, with a probability of 50%
The expected value, denoted by E[X]is calculated as,
E[X] = (0.5 ·3) + (0.5 · 7) = 5
Thus, the fair value of this gamble is equal to its expected value of 5 shillings, which is another way of saying that, faced with equi-probable payouts of 3 and 7 shillings is the same as receiving 5 shillings with certainty.
Symbolically, Huygens’ gamble can be represented as a discrete random variable X, with a set of possible payouts 𝑥i ∈ {3, 7}, and an associated probability distribution 𝑃(xi) = 0.5 for all 𝑥i ∈ X. The expected value of the game can then be written as:
E[X] = ∑𝑥i𝑃(xi)
The rational gambler, one is led to believe, is the one who seeks to maximise their expected value. Bernouli began his great paper by surveying the emerging consensus, saying:
Ever since mathematicians first began to study the measurement of risk there has been general agreement on the following proposition: Expected values are computed by multiplying each possible gain by the number of ways in which it can occur, and then dividing the sum of these products by the total number of possible cases where, in this theory, the consideration of cases which are all of the same probability is insisted upon. If this rule be accepted, what remains to be done within the framework of this theory amounts to the enumeration of all alterna-tives, their breakdown into equi-probable cases and, finally, their insertion into corresponding classifications.
As Bernoulli realised, expected value theory assumes that risks are identical for all counter-parties, and objective, leaving one to the easy task of simply estimating possible payouts and their associated probabilities and ranking gambles by their expected values.
Again, from my master’s thesis,
Huygens’ belief that the game amounts to being given the expected value is of course obviously both true and untrue. For instance, there is a material difference if one picks the hand with 3 shillings over the hand with just 7 shillings. The truth of Huygens’ statement rests on the dynamics of the game as we repeat it. If we played Huygens’ game 100 times, the mean payout might be 4.8. Per the central limit theorem, as i →∞, the mean payout approaches the expected value. The more we play, the closer we get to the limit of the game, i.e. the expected value. If we play this game 1 million times, the mean payout might be 4.999444.
Expected Value Theory Assumes that Wealth is Additive
The trouble with Huygens’ framing is that it creates a no-loss scenario. Regardless of the payout size, in this gamble, it is impossible to lose for one will win either 3 shillings or 7 shillings, with equal probability, and the fair value of this gamble is 5 shillings. When one introduces the possibility of loss into a gamble, the pitfalls of expected value are flung open.
Let w0 be one’s initial wealth with a value of $5,000 and Xi be a random variable representing the multiplier applied to wealth at the ith gamble:
Outcome 1: 1.4 with a probability of 50%
Outcome 2: 0.6 with a probability of 50%
The expected value of this gamble is, of course,
E[X] = $5,000*1.4*0.5+$5,000*0.6*0.5 = $5,000
This gamble leaves the value of one’s wealth untouched. It is the sort of gamble one would take purely for intellectual amusement but not to make any money. Although one’s wealth may decline one round, and increase another, over time, one’s payout will, according to our understanding of expected value theory, converge upon one’s initial wealth. However, there is a flaw in this thinking. Expected value is a one-round view of a gamble, it is as if an infinite ensemble of people played one round of a game and their average result was calculated. It is a theory of snapshots. Wealth, however, is not static, it is dynamic, unfolding through time, the outcome of one round in a gamble becoming the starting point of the next. To use a very ugly but very technically correct framing, wealth compounds multiplicatively, not additively, breaking the back of classical expected value theory in the context of long-term investment decisions. What one needs is not an ensemble average but a time average, for while in ergodic processes ensemble averages are equal to time averages, investors act through non-ergodic processes, where the ensemble average is distinct from the time average.
The Prospect of Ruin Stalks Every Investor
When one invests through time, each gain or loss changes the initial or prior wealth from which future gains or losses are calculated. Consequently, the arithmetic mean, which is essentially what the expected value is, does not capture the relevant quantity. What concerns investors, whether they understand the theoretical aspects or not, is the geometric mean, or, more precisely, the expected logarithmic growth rate. In our example, while the expected multiplier per round is 1 (leaving wealth ostensibly unchanged), the expected value of the logarithm of the multiplier is negative. That is,
E[logX] = 0.5⋅log(1.4) + 0.5⋅log(0.6) < 0
So, even when a gamble is “fair”, which is to say that there are equal chances of winning and losing, an investor is likely to lose over time. Wealth tends towards its own destruction. The arithmetic mean of payouts is irrelevant when the process that governs outcomes is multiplicative. The trap of expected value is that it hides this dynamic.
In a letter to Fermat in 1656, two years after the fecund correspondence on the problem of points, Pascal gave a formulation of what is now known as the gambler’s ruin problem. A ruin problem is one in which the outcome of a gamble has some chance of being an unrecoverable loss. Pierre de Carcavi summarised Pascal’s view in a letter that year to Huygens, saying,
Let two men play with three dice, the first player scoring a point whenever 11 is thrown, and the second whenever 14 is thrown. But instead of the points accumulating in the ordinary way, let a point be added to a player’s score only if his opponent’s score is nil, but otherwise let it be subtracted from his opponent’s score. It is as if opposing points form pairs, and annihilate each other, so that the trailing player always has zero points. The winner is the first to reach twelve points; what are the relative chances of each player winning?
Huygens went on to give the classic formulation of the problem in De ratiociniis in ludo aleae in the following way:
Problem (2-1) Each player starts with 12 points, and a successful roll of the three dice for a player (getting an 11 for the first player or a 14 for the second) adds one to that player’s score and subtracts one from the other player’s score; the loser of the game is the first to reach zero points. What is the probability of victory for each player?
Two players facing off for a fixed pot, exchanging points until one player is ruined. This is the world that investors inhabit. In many ways, the fundamental insights here were likely not novel even in the time of Pascal, Fermat, Huygens and Bernoulli. Although the pre-Pascalian era did not give birth to a mathematical theory of probability, traders estimated a price for risk and aleatory contracts were written in which the prospect of ruin was clearly foreseen. In my masters thesis, I cited James Franklin’s fabulous book, The Science of Conjecture, when explaining that,
Under Roman law, the risk of a shipwreck was assumed by the state. Risk was reified and regulations defined under which risk could move from one party to another. Maritime loans were allowed to have higher interest rates than permitted for other loan products, because of the heightened uncertainty of maritime trade, with the Digest saying, ‘the price is for the peril’.
Even today, although the typical analyst, portfolio manager or investor is unaware of the theory and its implications, economic and financial literature and education understand the superiority of compound returns over expected returns, and the ruin problem is a building block in actuarial math. However, vast areas of influential thought are bereft of any notion of ergodic and non-ergodic processes, such as behavioral economics. Daniel Kahenman and Amos Tsversky’s Prospect Theory is, as I will show later, built upon a misunderstanding of wealth dynamics. What follows in this series is an attempt to provide investors with a more holistic vision of risk and uncertainty and how one navigates them.
Initiatd on the 4th of April 2025, this position was closed on the 8th of April 2025, from a sense that the market had baked in the likelihood of China’s non-compliance with President Donald Trump’s ultimatum to lift sanctions. The position closed with a return of 34.11%.
Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.
William Butler Yeats
One of the great puzzles of the economics of risk is the insurance paradox: assuming a world of expected value maximisation, why does a market for insurance exist if the price at which insurers are willing to provide it is higher than the price at which consumers are willing to pay for it? A solution suggested as early as the eighteenth century by Daniel Bernoulli in my favourite mathematics/finance paper of all, “Exposition of a New Theory on the Measurement of Risk”, gives a powerful answer: in a world where , in the long run, catastrophe is certain, one needs insurance to emerge from catastrophe wealthier than one would without it. Insurance makes the insurer and the insured wealthier.
This is not a long-term thesis, but a short-term, tactical thesis to help navigate the risks of the coming days, and weeks. One of the great realisations I had when I wrote my as yet unpublished Masters’ thesis, “The Nature of Risk”, is that losses have a greater impact on portfolios than gains. In a sketch of an idea, named after my masters thesis, I explained that,
Losses impact portfolios more profoundly than corresponding gains. In truth, although perhaps controversial, this can be shown with very elementary arithmetic: a decay in wealth of 10% requires an 11.11% gain just for an investor to break even, while a 20% decline requires a 25% gain, a 50% decline demands a 100% gain, and a 99% decline requires a miracle. As losses mount, the gains needed just to break even escalate asymmetrically. Whether these losses come in one fell swoop, or in dribs and drabs over time, the demands on a portfolio to earn asymmetrically greater returns soar. Managers and investors are rationally obliged to avoid risk, investing only when they have an edge, and, when doing so, investing in concentrated portfolios, while diversifying across time.
For many investors, this will be a period of escalating losses requiring asymmetrically greater gains just to break even. I see this period as, at a minimum, analogous to the COVID-19 crash, as a period of systemic downturns, an idea that informed my thesis on gold and gold miners. Here, I argue for a tactical, short-term deployment of the ProShares Ultra VIX Short-Term Futures ETF (UVXY) over a holding period of one week to one month. The aim is to not only capture upside potential in hedging volatility but also to protect a concentrated 10-stock portfolio, where 30 to 40% of the value is exposed to steep downturns -such as my position on Meta Platforms-, against tail risk. I suspect I will start off at a loss, and this will carry on till Monday, but as the trade war intensifies and apocalyptic nightmares stalk investors, the UVXY will storm forward.
Downside Volatility Will Be Sustained
At one point, the Wall Street Journal reported that April 3 experienced the second biggest daily loss in U.S. stock market value, with an estimated $3.1 trillion dollars wiped off the market. The WSJ quoted Rob Citrone, a tariff-skeptical hedge fund manager who had bet that the early rally was “crazy”, as saying, “I should have sold more”. I think that that feeling is widespread. When the debris has cleared, there will be a lot of value to be had. I suspect I acted too early with Meta Platforms: the thesis was sound, the timing was terrible. Some investors, citing Warren Buffett’s famous axiom, “Be fearful when others are greedy and greedy when others are fearful”, may swoop in, but that only works if the losses incurred are not so great that one needs a miraculous Covid-sized bounce. Some stocks may not recover for years. The Financial Times later reported that the final losses were $2.1 trillion. My arguments from my gold and gold miners piece remain: we have entered a period of such uncertainty wherein selling will beget more selling, as market participant’s rational fears and their deleveraging and de-risking act to make the market more risky for holders of stocks, a moment of negative momentum, and capital outflows from stocks into gold and other perceived safe haven assets. Furthermore, we await the counter moves of the U.S.’ major trade partners, all of whom have promised strong, carefully considered reactions. This season of mutual blood-letting will send markets into a death spiral until the trade war is called off, or, until there is a sense that a grand bargain can be achieved.
Although value will likely outperform growth, the typical value investor will still return very low returns because of the gravitational pull of this market mayhem. Moreover, because, at 52%, U.S. portfolios were allocated to equities at their highest levels since the Federal Reserve started collecting data in Q1 1951, there were already rational reasons for the aggregate portfolio to exit stocks. This is an era of rational panic. That means, for the next few days to a month, downside volatility will define the market.
The UVXY inversely correlates with the S&P 500 so that during periods of systemic distress, it benefits from these cycles. As the fund sheet explains,
ProShares Ultra VIX Short-Term Futures ETF seeks daily investment results, before fees and expenses, that correspond to one and one-half times (1.5x) the performance of the S&P 500® VIX®Short-Term Futures Index.
However, the dear reader should note that trading such instruments incurs significant transaction costs, with the UVXY having a gross expense ratio of 0.95% compared to 0.0945 for the SPDR S&P 500 ETF Trust. Insurance is expensive. One has to believe that downside volatility will be deep and sustained enough for this to make sense. One must balance the expected gains from hedging with these costs, especially over short holding periods.
Past Analogies
While I suspect that this crash will end up greater than the Covid-19 crash, one can use it as a way of benchmarking expectations. Between March 1 and April 1 2020, the S&P 500 slumped some 16.4%, compared to a rise of 187.7% for the UVXY.
When the UVXY first entered the market October 31 2011, in the wake of the August 2011 stock markets fall, the S&P 500 fell 4.64%, while it gained 21.75%, between October 31 and November 29.
The final analogy is indirect: during the 2008 financial crisis, specifically between 1 August 2008 and 30 July 2009, the CBOE Volatility Index (^VIX) gained 27.6%, while the S&P 500 declined 28.3%.
These are the results of a simple buy-and-hold strategy of an instrument that is typically deployed for very short periods. The results are even greater when the VIX is deployed for shorter periods, before decay sets in as the market recovers. At a base value, I expect to gain 20% over the next month from the UVXY, and higher than that in short bursts.
Execution and its Risks
The reader will have to work out the appropriate position sizing and risk management tactics based to offset potential losses. My guess is that losses could be as large as 30% for the year for this period and by extension, for my risk-exposed positions. To sketch out how to think about it, let V denote the portfolio value and H the hedge allocation. My goal is to choose H such that:
H = (L⋅V)/ΔPETF
where:
L is the maximum acceptable loss (targeting a reduction in risk exposure by at least 30%),
ΔPETF is the expected percentage move in the ETF during a crash event.
That allocation can be dynamically adjusted using Bayesian posterior estimates.
The instrument is itself volatile, so a stop-loss order is crucial to preventing a market rally adverse events from exacerbating losses. I recommend setting a stop-loss at a level where losses exceed a predetermined fraction of the hedge position (typically 20 to 30% of H). The UVXY is designed such that it suffers a decay due to futures roll costs, especially in a contango environment. This can erode returns if the market remains volatile without a sustained crash. There is also the issue of timing uncertainty. Miss-estimations are the norm, and can lead to over-or-under-hedging. I could go on. Simply: this is not a guarantee of a gain, either because a sustained crash does not happen, and the fees incurred leave the investor at a net loss, or because the UVXY may not hedge against such a sustained crash in the expected fashion.
Conclusion
Nevertheless, with the commencement of a global trade war, the prospect of stagflation, geopolitical uncertainties fast-emerging, and the possibility of tighter monetary policy, the probability of a sustained market downturn has increased. What is proposed is a tactical, short-term position in the UVXY as a hedge against systemic market crashes. By combining Bayesian probability with quantitative models for position sizing and risk management, and by accounting for transaction costs and market microstructure, the proposed strategy offers a robust framework for preserving portfolio value in these turbulent times. Nevertheless, there are inherent weaknesses, such as the leveraged decay, liquidity risk, and model uncertainty, and these must be closely monitored.
