Disability as a Defensive Asset Class

In today’s turbulent financial environment the next horizon could bring gain or ruin. The concept of portfolio risk management means something very different today than it did six months ago. While the mind goes to stocks, one can look at a company as a whole as a portfolio of businesses, or assets, that generate returns for its owners. These assets generate a risk profile for the entity, with a diversified defense contractor carrying less risk than a focused tech firm. Let’s not even discuss financial firms.

As firms evaluate their asset mix in times of crisis, like today, they quickly realize that decisions made in good times either secure their future with lower risk, or jeopardize future viability by putting ‘too many eggs in one basket’. Usually it is too late to change the asset mix when the ‘stuff hits the fan’, and Monday morning quarterbacking becomes a gut-wrenching exercise that keeps senior leaders awake in the wee hours of the morning.

Defensive assets are traditionally defined as income bearing assets like bonds. They serve the purpose of reducing risk in a portfolio. When we look at the balance sheet of a company, essentially a firm’s portfolio, defensive assets are those that are not correlated to the other assets through which the company makes money. A good example of a defensive asset would be a sports car company that also manufactures military vehicles. In tough economic times, folks buy fewer sports cars, but the government always needs tanks. The military contractor represents a defensive asset as its sales are largely unrelated to sales of sports cars.

Disability can be seen as a defensive asset class. The most obvious defensive piece of this asset class is the $480B annually that pours into this space through government transfers in the US alone. For contextual purposes, this equals 87% of the defense budget. These dollars represent a stable revenue source to fulfill customer desires. A large proportion of these dollars are in areas such as health care, transportation and housing. Much of these dollars are heavy with bureaucratic fat, ripe for an innovator to competitively spin a better product with more efficiency. Great upside with a stable revenue source, the epitome of a defensive asset.

In a broader context, disability as a marketplace is untapped. As an untapped marketplace, the annual volatility tends to be lower than the market as a whole simply because initial contribution growth is higher and more stable. In layman’s terms, first movers are like the only gas station in town, business flows because it’s the only game to be played. This has the effect of lowering correlation to areas of the firm that are more mature, which tend to be more impacted by moves in the overall economy.

For most firms riding out this downturn, it’s too late to have any meaningful impact on their balance sheets . Good managers are now looking ahead to the next downturn to immunize their revenue sources. One way to do this is to find new sources of revenue that are material to top line growth. The true beauty of disability is that it represents a new segment that is embedded inside geographic/political markets that companies already serve. It does not require a massive re-tool or capital outlay, simply a shift in message and vision to get started. . A firm does not need to build new infrastructure as they would, say, to enter into an unknown environment like China or Africa. In fact, it should take less time than an economic cycle to have a material impact on a firm’s revenue profile.

When the economy gets ugly, firms take hard looks at their asset mixes. Those firms that fail look from a forensic lens, those that survive to thrive assess from a position of lessons learned. Warren Buffett, the world’s best-known value investor has proven that times of crisis are times to step into the breach and buy quality assets. Disability represents one of the best opportunities in today’s marketplace for material growth at a reasonable price that also works to reduce the volatility of revenue streams. Whether the firm is a retailer, an airline, a tech firm and, yes, even a bank, the opportunity in disability to diversify assets cannot be ignored.

As money managers seek to diversify their allocations, disability represents an asset class in-line with consumer staples, health care and defense contractors. It also represents an asset base whose upside is aligned with value investing, deep discounts that will tend to fair value over time. The major difference with disability as compared to other emerging asset classes(alternative energy, aerospace, high technology) is that the revenue models are robust and easily understood, while the cost side is fat and padded. Capital will flood this space soon.

Risk is always ignored as an issue in the media until something goes wrong. Upside does not sell newspapers(or attract web hits). In the real world, senior managers of revenue producing firms must be exceedingly good risk managers. We’ve seen the results when they are not. Shareholders are demanding that managers find the magic bullet; increased growth with lower risk. Disability represents exactly that.