Thread by @Sanjay__Bakshi

Interesting live case study on herding and precautionary principle. On herding, soon regulators in nations who have not grounded 737 Max (India?) will feel the pressure to conform to the behavior of those who did.

https://twitter.com/ceoworld/status/1105383987739004928

Herding as in "we need to do what everyone else is doing."

Precautionary Principle as in "even if we don't know if technical faults caused the crash but it's better to be safe than sorry."

Additionally, one should observe how different people behave.

1. The airlines who operate 737Max almost exclusively
2. The airlines who have some 737 Max planes
3. The airlines who have no 737 Max planes (key beneficiaries of grounding)
4. Airline Regulators
5. Boeing
6. Airbus

If you look carefully, you'll find that so far, the stakeholders are acting in accordance with their own interests. Boeing is defending the use of the plane, and airlines with heavy reliance on 737Max are doing this too.

And one after another, Regulators are following in line with those who banned 737MAX early. I am not criticizing this move. Merely commenting on the social pressure to conform. India banned it last night, just hours after its decision to not ban.

When you think of the regulators, you should think of their own personal gain/loss ratios. Under current circumstances, a regulator has very little incentive to resist the social pressure to conform. There is little upside and huge potential downside of non-conformity.

There is one big holdout so far. The US. Guess why? Boeing is an American company. But even here the pressure is mounting. From politicians and from the passengers. Will the US Regulator capitulate?

Meanwhile, everyone (the Regulators and the Airlines including those who are defending the use of 737MAX) is saying that passenger safety is their first priority. That's another illustration of the need to "watch what they do, not what they say."

Airlines which do not use 737MAX planes and Airbus, are keeping silent. Which, of course, is the correct thing to do in the circumstances despite (or because) both are huge beneficiaries of this crisis. The model to explain their behavior? "Undertaker in a Plague."

What are the other lessons? One, is that we now have a new source of fragility in the airline industry. List of other sources is too long and too commonly known so won't reproduce it here.

This new source (at least from me) of fragility in the airline business comes from over-concentration on one type of plane.Up until now, this concentration meant less money spent on training, spares etc. It reduced cost and improved profitability in a business with low margins

But now we can see what can happen to an airline which uses only one type of plane. If something happens to that type of plane, and you have a fragile balance sheet, and can't fly them for a while, then the consequences can be deadly.

Another aspect is to compare what's happening in the minds of airline regulators with what happens to the minds of fund managers when they find a security in their portfolio which is increasingly being regarded as toxic by other people.

The reasons for people believing that security to be toxic may be valid or invalid. Therein lies the similarity between the two situations. In 737MAX, no one wants to be seen to be flying that plane. In portfolios, no fund manager wants to be seen to be owning that stock.

In 737MAX, it makes sense to ground the plane. What about the "toxic" stock in a portfolio? This is a very interesting question.

And it's a fascinating problem from a decision-tree viewpoint. At the time when some shit is reported about a company, one does not know if the news is true or not. If it's true, the fair value of the stock could be much below the current market price.

If the news is false, it may be an opportunity to buy. So blind contrary behaviour could produce profits. Or losses.

The problem becomes interesting because one would often never know if the news was true or not. And the decision to do nothing, if one is long, is also a decision

And I guess in such situations, having the mindset of a trader, is appropriate. Traders don't have emotional attachment to what they own. So they are far better off dealing with such problems.

The problem, of course, is that traders also have much smaller concentration in their portfolios and so their trigger-happy decisions, even if they are wrong, have limited downside. They also carry liquid positions most of the time.

That's not the case with investors who have larger positions which are often also illiquid, or become illiquid when the bad news hits.

And so the key question for investors who have long positions in stocks of companies which are suddenly deemed as toxic by a large part of the investment community is this: Should they use the Precautionary principle like the airline regulators are doing right now?

Mr. Market does exactly that, no? On 1st sign of some fraud based on a news story, which may or may not be true, it derates the stock massively. And re-rates it later if the story was wrong. Mr. Market, in that sense, is no different than many airline regulators.

What about you?