Contemplating Risk

Contemplating Risk

Investing means dealing with uncertainty, and risk, by its very nature, is unquantifiable. But while it is impossible to predict the future, it can be a very useful exercise for investors to rigorously consider a range of possible outcomes for a business, with a particular focus on the downside.

As Howard Marks from Oaktree Capital describes in his book, The Most Important Thing Illuminated:

The possibility of a variety of outcomes means we mustn’t think of the future in terms of a single result but rather as a range of possibilities. The best we can do is fashion a probability distribution that summarises the possibilities and describes their relative likelihood. We must think about the full range, not just the ones that are most likely to materialise. Some of the greatest losses arise when investors ignore the improbable possibilities.

While we may be unable to quantify the likelihood of possible outcomes, simply trying to identify a worst case scenario can go a long way in determining the comfort with an investment.

Let me frame this discussion around our assessment of Australian Careers Network (ACO), which is a collection of Registered Training Organisations providing vocational education. We were first introduced to ACO in early October 2014 when the company was seeking capital at $2.50 per share to float on the ASX.

At this time there was no awareness of the turbulence that would engulf the sector. If everything went according to management’s plans, we considered ACO could be worth $3.10 per share. But a rigorous analysis of the business raised a multitude of red flags which included (but were not limited to):

• The leverage of the business to Government funding
• The skew of the earnings to higher margin courses
• The high proportion of capital flowing to the owners from the float
• The speed at which the company was coming to market
• Limited disclosure of the partnerships with education providers
• Key man risk
• A high proportion of acquisitions

We thought the funding arrangements in the industry allowed vocational training providers to generate excess returns, and felt it was likely that the Government, as the primary funder, would eventually curb this excess in some form. Now, we couldn’t quantify the likelihood of adverse effects on the company’s earnings, but with this process we saw the risk of capital loss as meaningful and decided against investing.

Two weeks after this review, Vocation Limited (ASX: VET), another vocational education provider, announced that the Victorian Department of Education and Early Childhood Development (DEECD) would discontinue funding certain qualifications as a result of inadequate controls. Vocation’s share price opened 60 per cent lower on the news.

Now, Australian Careers Network went on to raise equity at the considerably lower price of $1.70 per share, and floated in December 2014 at $1.38. Even with the share price trading at half of what ACO originally sought, we considered the likelihood of an adverse event had increased on this development and felt the loss of capital was still significant.

Australian Careers Network went on to report its 2015 full year results without incident. As time passed, the market began to view Vocation as an isolated event, and ACO’s share price rose above our initial assessment of $3.10. It seemed the market’s assessment of the worst-case-scenario had improved, or at least considered the likelihood of an adverse event had meaningfully declined.

Yet on 15 October 2015, ACO entered voluntary suspension announcing areas of non-compliance had been identified by regulators. Media reports have suggested that the registration of a subsidiary may be cancelled.

When we initially reviewed ACO, we could not predict that it would be suspended in 12 months. Remember, we cannot accurately define the probability of an event occurring, so the assessment of risk is really a matter of opinion. But we find that our investment process benefits when we rigorously consider the range of possible outcomes to a business.

Ben MacNevin is an Analyst with Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.