The 12 Days of Investing

– DAY 9 –

The Trinity of Risk

Valuation risk, business risk and balance sheet risk

At Pender, we consider ourselves owners of a business, not just its stock, which means that when we think about risk we believe that real investment risk is not measured by fluctuations in a stock’s price, but by the probability of a “permanent loss of capital”. We therefore focus on three main factors during our investment analysis process:

Valuation 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.

Business Risk – The danger of a loss of business quality and earnings power through economic change or deterioration of management. The presence of competitive advantages like scale, patents and well-loved brands help to reduce business risk. To quote Benjamin Graham, the father of value investing, “The chief losses to investors come from the purchase of low quality securities at times of favorable business conditions”.

Balance Sheet Risk – Investors tend to ignore balance sheet and financial risk during stock market booms. They can be focused on cyclically high earnings and forget how damaging recessions can be to highly leveraged companies. Companies that place a high priority on maintaining a conservative financial profile are more likely to survive the challenges faced by most companies from time to time.

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How Pender Thinks About Risk

We are old fashioned when it comes to our definition of risk. We concur with the dictionary’s basic term…“the possibility of loss or injury”…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.

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Assessing Company Risk; Managing Portfolio Risk

David Barr and Felix Narhi record a two part series on risk. In Episode 5, they discuss the trinity of risk, their approach to evaluating each type of risk and the role of behavioral psychology and staying within your circle of competence. In Episode 6 they move from talking about risk assessment at the company level to risk management at the portfolio level.

Listen to Episode 5 Here

Listen to Episode 6 Here

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The 12 Days of Investing

We’re marking the holidays with the 12 Days of Investing the Pender Way. Short posts in which we share some of the key tenets of our investment process.

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