A monkey randomly hitting computer keys for an infinite amount of time will in due course reproduce all the works of Charles Dickens. This monkey would also type everything written by Shakespeare, Hemingway, Achebe, the Harry Potter stories – you name it. This may sound absurd, but that it’s mathematically correct becomes obvious once we break down the numbers.

This is how it works. What’s the probability that the monkey will type the letter ‘A’? If the keyboard has 40 keys, the chances of typing ‘A’ are 1/40 or 2.5%. Not bad for a monkey typing at random.

But what are the chances that our simian author will spell the word ‘APPLE’? Since the monkey types at random, there’s an equal chance of striking any key and so the probability of typing ‘APPLE’ is:

1/40 * 1/40 * 1/40 * 1/40 * 1/40 = (1/40)5 = 1 in a 100 million

Odds of one to a hundred million aren’t great, but it remains mathematically possible because it’s higher than zero.
Now the likelihood that the monkey won’t type ‘APPLE’ is: (1 – 1/405)n

Where n is the number of times the monkey can type the word. If the monkey is typing at random for an infinite amount of time, n approaches infinity and the probability of not typing ‘APPLE’ approaches zero. In plain English, this simply means that given enough time, even low probability events can compound to become a certainty.

In investing, understanding how comparatively low probabilities can compound to
become near certainties is very important. Imagine two companies, Company A and Company B. In any given year, Company A has a 10% chance of going bankrupt while for Company B it’s 1%.

In any single year, there isn’t much difference between the 1% or 10% probability. Even though a 10% chance is obviously greater than a 1% chance, they’re both less than 50% and so bankruptcy is equally unlikely.

But over a 10-year period, the typical length of a business cycle, those probabilities compound. The odds of Company A going bankrupt jump to 65%. And for Company B the odds are now 10%. The difference between 65% and 10% odds is significant and Company A is now more likely than not to go bankrupt. Intuitively, what is happening is that in a changing commercial environment, the conditions in which Company A will get into trouble are more likely to arise over a business cycle than in any given year.

Over-extended borrowing is one of the most common factors to bring a company down, and this is why at Tacit we avoid over leveraged companies at all stages of the economic cycle, especially now. After 10 years of very low interest rates, corporate debt levels have increased markedly while default rates remain low. But with rising interest rates, rising input costs, and rising wages, the likelihood of defaults will inevitably increase. In any one year, the probability of a default remains low but given enough time, it becomes a near certainty because of the compounding effect of probabilities.

The shift to positive ‘real’ interest rates will no doubt cause issues for weaker companies over the next few years. This is a natural process and in our view it is ultimately healthy for the global economy in the long run.