Fragility and optionality in business models

Contributed by : Rajni Dhameja, CFA

CFA Society India organised a session on August 04, 2018 on “Fragility and optionality in business models” by Prof. Sanjay Bakshi.

Key takeaways are as follows.

Fragility as defined in Cambridge dictionary means the quality of getting easily damaged. In business context fragility would mean the business being vulnerable to the fragility. There are various factors which can make business vulnerable to fragility. This fragility can come from various sources, few of those are discussed below:

  1. Lack of entry barriers : Lack of entry barriers causes fragility in the business in a way that the business loses its competitive advantage eg: Go PRO
  2. Business where the both input and output is commodity are susceptible to fragility. On the other hand the business where the input is commodity and output is brand, has competitive advantage as the brand can give it the pricing power.
  3. Disruption through innovation can bring fragility to the existing business
  4. Dependence on one or few customers, dependence on govt. subsidies, dependence on kindness of others can be a major source of fragility in the business
  5. Dependence on the price of something that is volatile and beyond control can bring out the fragility in the business
  6. Rigid cost structures can also cause the fragility in the business
  7. Gambling tendencies in the business can bring about the fragility

As can be seen from above that fragility can stem from various sources hence in few cases it becomes inherent part of the business. Now the question arises how to deals with it. Ways to deal with it:

  1. If it is unacceptable, avoid it completely
  2. Ignore it completely and then later on face the consequences
  3. Being pragmatic: Be aware about the presence of fragility and then act consciously. Eg: Portfolio sizing, taking calculated bets

Optionality lies at the other end of spectrum from fragility. Optionality has unlimited gains, limited losses whereas fragility can bring unlimited losses. As opposed to fragility, optionality is desirable. Fragility depends on luck on the other hand bad luck in optionality is not fatal, whereas good luck can bring big bang gains.

Look for the business which has optionality in it. Value investing is an example of implementing optionality, wherein you do not pay for growth. Being aware about both fragility and optionality enables you to size your portfolio in optimum manner.

 

– RD

 

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