“All investment evaluations should begin by measuring risk.”
— Charlie Munger, Vice Chairman – Berkshire Hathaway
We are old fashioned when it comes to our definition of risk. We concur with the dictionary’s basic term, which defines it as “the possibility of loss or injury”. We agree with this fundamental definition, but we augment it with an important addendum to make it two-pronged. To us, real investment risk is the risk of permanent loss of capital and the risk of an inadequate return. We believe investors who are seeking to grow their wealth over time should embrace both important nuances in order to stack the odds in their favour.
On the other hand, many academics and investors like to define investment “risk” differently, maintaining that it is the relative volatility of a stock price or a portfolio of stocks compared to a wide index of stocks like the S&P500 (i.e. beta). Using extensive databases and statistical techniques, investors can precisely calculate the beta of a stock. Many use it as their singular, all-encompassing measure of risk. If only the real world were that simple. While volatility is precisely measurable, uncertainty and real investment risk are not. Moreover, real world data has confirmed that the underlying assumptions used to calculate beta are flawed. Our view of real risk is decidedly more nuanced. Rather than seeking clues about risk from the volatility of stock prices, we seek to inform our views at the fundamental business level, much as a private business owner might.
Sometimes risk and reward are positively correlated and many investors accept this concept as almost a universal truth. However, the reverse is true when practising value investing. If an investor buys a dollar of intrinsic value for 50 cents, it is less risky than if that investor buys a dollar of value for 70 cents as there is more downside protection, but the expectation for reward is greater in the first case. Lower risk, higher return: Isn’t value investing fun?
There are three primary interrelated sources of danger that need to be avoided:
- Valuation risk is perhaps the most obvious risk. If an investor over pays for a stock, it doesn’t matter how well the underlying business performs, the returns will likely be mediocre or worse. Prospective long-term returns for any given stock will largely depend on whether the stock was bought at a discount to its intrinsic value and the underlying economics of the business itself. Over the long term, it’s hard for a stock to earn a better return than the business which underlies it earns, which leads us to our second danger.
- Business risk is the danger of a loss of business quality and earnings power through economic change or deterioration of management. The competitive reality of capitalism is such that most small companies stay small and most large companies become mediocre. Worse, as the pace of technological change continues to accelerate, the forces of competitive destruction are becoming even more intense which puts even well run companies at risk. The presence of competitive advantages like scale, patents and well-loved brands help to reduce business risk. Nevertheless, complacency is not an option. As Benjamin Graham, the father of value investing opined, “The chief losses to investors come from the purchase of low quality securities at times of favorable business conditions”.
- Balance sheet risk is the third danger. Investors tend to ignore balance sheet and financial risk during stock market booms. Instead they become focused on cyclically high earnings and forget how damaging recessions can be to highly leveraged companies. Many, if not most, of the world’s most spectacular bankruptcies have occurred thanks to a combination of business risk and overleveraged balance sheets. Companies that place a high priority in maintaining a conservative financial profile are more likely to survive the inevitable bouts of bad luck, business cycles, mismanagement and other changes that inevitably impact most companies from time to time.
Most investors intuitively understand that trying to avoid catastrophic losses is a good thing, but many deal with this danger by placing their money in ultra-low volatility securities like t-bills in the United States or GICs in Canada that have little or no real return. Under most foreseeable economic scenarios, it is hard to see how one can obtain an adequate return following such a strategy over an investment lifetime. Indeed, it reminds us of a tongue-in-cheek disclaimer in a recent energy company’s investor presentation which read, “Don’t forget about risk-free and return free T-Bills in your portfolio… After inflation and taxes you’ll likely only lose 5-10% of your investment”. Only by very loose definitions can such a strategy be called investing. An investment policy that virtually ensures losses of purchasing power over time is very dangerous if your definition of risk also includes the risk of inadequate return. Volatility may be low, but the real investment risk is clearly high.
Many investors start their investment evaluation process by asking “What is the upside?” Value investors invert this process and ponder “What is the downside risk?” We believe it is very important to distinguish between real investment risk and volatility. Seeking to avoid permanent loss of capital, rather than short-term stock price quotational risk, should be a top priority for most, if not all, thoughtful value investors. Counter intuitively, enterprising investors who also successfully avoid downside risk should have a higher probability of outperforming the market. Mathematically, it makes perfect sense. If the stock market’s collective returns are driven by a universe of stocks with a wide range of returns for investors, owning a portfolio that successfully avoids more of the market’s big losers should be market beating strategy over time. It is addition through subtraction.
Intelligent investing has more in common with running a marathon than running a sprint. However, one can’t win the long-term investing race if you don’t make it to the finish line. Properly practiced, value investing has been a market beating strategy over time because it begins with measuring downside risk. Nevertheless, it behoves investors to keep in mind that the future is always uncertain and risk taking will inherently be failure-prone at times, no matter what precautions an investor takes. Otherwise, it would be called sure-thing taking.
Felix Narhi, CFA