“The goal in investing is asymmetry: to expose yourself to return in a way that doesn’t expose you commensurately to risk…
…but that doesn’t mean the avoidance of all losses is a reasonable objective.”1
– Howard Marks
The release of Howard Marks’s latest (and excellent) investment memo is an opportune moment for me to write the third post in a series explaining what unconstrained investing means to me. The subject this time is risk. I’ve begun the post citing Marks, who is a very rare breed in the investment world. Not only does he have over four decades of investment experience with a very impressive track record, he has also been kind enough, through his prolific writing, to share all his secrets with anyone who is interested. Although Marks’s expertise is primarily in bond investing, his philosophical approach to risk – summarised in the above opening quotes – is equally applicable to equity investing and has been very influential to me.
In my first post on unconstrained investing – Benchmark blues – I outlined how my unconstrained approach differs from many other stock market investors in that I prioritise absolute over relative factors in all investment decisions. When it comes to risk, this means asking the question: how much money can I lose and how likely is this to happen? In practice this entails plodding through all the things that can realistically go wrong, and trying to assess how serious they would be for a company’s business model, balance sheet, or valuation. I am not interested in the relative risk of owning (or not owning) one particular share versus another, or versus a wider equity benchmark.
I believe most important risks can be put into one of three broad categories, a process which I find helps me to gauge the overall risk of a particular investment. But before I explain what these three categories are I want to make two general points as to the purpose of this exercise.
– The objective here is not to eliminate or reduce risk. Investing in equities always involves a degree of risk. Rather, I am trying to identify firstly what the key risks are, and secondly to make an assessment of how much downside there is should any given risk materialise. This latter point is particularly important for me. In the past I have rejected many investments on the grounds that I have been unable to make a reasonable assessment of how much downside there is. I’ll give some example of these below. The final and most subjective part is to put a probability on any given risk materialising.
– Although I am trying as far as possible to identify and quantify risks, in practice this is more of an art than a science. Unlike bonds, where there are usually contractual cash flows and maturity dates that can be modelled, equities tend to offer no such return guarantee and often little in the way of asset security. Downside risk assessments are therefore inevitably more qualitative, subjective and offer lots of scope for debate and disagreement (much more interesting than bonds!).
Back to the three risk categories… Owning a share entails owning a small stake in a company. To understand the risks to the share we must understand the risks facing the company. All companies consist of assets – for example factories, employees, brands – and the liabilities that fund those assets such as debts, pensions, working capital and of course the equity shareholders. Risks reside in all these areas, and we can break them down as follows:
1. Business risk affects the asset side of the business. These are risks that may cause a company’s business model to perform poorly or in extreme cases disappear altogether. A common example is economic cyclicality, where a company’s profits can fluctuate significantly with the ups and downs of the economic cycle. One sector I have avoided for many years due to high and unquantifiable business risk is mining. Profits are very dependent on high commodity prices, which in turn are dependent on the continued growth of the Chinese economy. The extreme and unbalanced nature of the Chinese economy has made it virtually impossible in my view to work out what the downside is for commodity prices and hence mining company profits.
2. Financial risk is concerned with a company’s balance sheet. Financial risk is high when a company is very reliant on debt funding as opposed to equity funding. Or there may be other claims such as pensions, leases or contingent liabilities. Financial risk is fine as long as it is observable and quantifiable. Banking is one area where this is definitely not the case. The banking business model uses very high levels of debt funding which can be opaque and always seem to dry up just when they are needed most (i.e. in a downturn). This fact has always made it hard for me to invest in bank shares.
3. Valuation risk affects the price of a company’s shares. The stock market is a discounting machine, which means the valuation placed on any particular share tends to reflect the consensus view as to a company’s business and prospects. One of the most common instances of high valuation risk occurs when a significant amount of future profit growth is already priced into the share’s valuation. The risk materialises if the company does not deliver on the growth causing the share’s valuation to de-rate. Some of the recent technology and “online” IPOs fall into this category. Investors have been prepared to pay very high valuations today for expected but unproven future profits. See my colleague Matthew Hall’s discussion of AO World for a current example.
This approach to risk makes sense for me because it is consistent with my long term investment objectives, which are primarily absolute rather than relative. If I can be clear about the nature and scale of all the absolute risk factors then I can ensure that I am always being adequately compensated for taking them. However, the approach is not so suitable for investors whose performance objectives are more relative in nature, particularly over shorter time periods such as a year or less. This is because it can lead to portfolios that look very different to the broad benchmark indices and as such short term results can also look very different. I will expand on this in the next post on unconstrained investing which will discuss portfolio construction for an unconstrained investor.
1. Oaktree Capital, April 2014, http://www.oaktreecapital.com/memo.aspx