Guest Post: Thoughts on Risk.
RISK: Successful investing is all about managing risk and, as luck would have it, this is one of the things that we, as a species are not particularly good at.
It is demonstrably true that humans are terrible at evaluating the complex risks associated with modern environments. This is not new information and there are plenty of oft referred examples which you can probably bring to mind; how we assess the actual probability of death from road vehicles vs. the perceived risk of death from spiders, snakes, sharks and aircraft (1,414 deaths vs. 32 in Australia 2009), the detrimental health risks of nuclear power vs. the dangers of fossil fuels (for every nuclear power linked death, there are an estimated 4,000 coal related deaths. Both candles and wind power are linked to more deaths than nuclear energy), or the real risk of bacterial infection vs. swine flu or mad cow disease (septicaemia alone was responsible for 993 Australian deaths in 2009).
Even if we acknowledge this shortcoming and integrate this knowledge to inform our everyday decisions, humans are hardwired to act on perceived risk, and are thus influenced to varying degrees by emotion. This is an evolutionary thing, and was suitable during the times that most of our transition to the dominant species occurred, but far less so now. The data necessary to evaluate complex risk often requires computers to calculate, and gut feel just won’t cut it anymore. To make it worse, we (as an aggregated faceless mass of humanity) are more inclined to trust information that reinforces existing beliefs (a well established phenomena known as confirmation bias). In a world where prominent politicians (and others) oppose the use of vaccines responsible for the eradication of polio and smallpox, in direct contradiction of peer reviewed science, finding someone who will tell us that we are right about pretty much anything is not challenging.
In summary, our natural instinct is to assess risk using our perception rather than facts, our perception is very often wrong, and even if we go looking for facts, we are inclined to assign more validity to data that supports our predisposition rather than to conduct an objective assessment.
You want more? In an apparent contradiction, this inability to overestimate our abilities may even confer an evolutionary advantage. Unfortunately, this would work at a species level, rather than for the wealth of the individual, and is a complex topic for another day (more about it here van Veelen,M. and Nowak,M.A. (2011) Evolution: Selection for positive illusions. Nature, 477, 282-283)
So, why is this important, and how is it relevant to investment?
Investment, as we all know, is about accurately assessing risk, and requiring an appropriate return to compensate for these risks to our capital. The more accurately we can assess risk in our investments AND act accordingly, the more likely we are to maximize returns. Knowing that investment is about managing risk however, is VERY different, and a lot easier than doing the work that this understanding requires.
Risk is managed using facts and knowledge. There is no place for gut feel. The more relevant facts we have about an investment, and the more knowledge we have about how to integrate this mass of data, the more accurately we can ascertain risk. As investors, we are looking for opportunities where professionals, with millions of dollars allocated to data collection, and which have analysts with years of experience, have mispriced this risk.
It could be argued that this is not necessarily so, that we could accept the average rate of return, such as with an index ETF. In this case we are accepting the risk premium applied by the market, and the inferred risk premium is out of our control. Historically, the 10 year compound annual rate of return for the ASX is 2.4% (excluding dividends), and for 5 years -3.1%. Even going back 22 years to 1990 only gets you just over 4%. In my opinion, the reward over any of these time frames is clearly inadequate, even allowing for dividends. These returns are comparable or worse than much lower risk investments including cash (not accounting for tax).
This leaves us competing against experienced, well resourced professionals and, more dangerously, many not-so-great investors as we try to outperform the market. In this context a quick look at P/E ratios is unlikely to yield the stocks that will lead to suitable returns. We need to be able to value businesses, find those that are mispriced and, most importantly, identify and assess the risks inherent in our calculations.
There are many tools for valuing businesses, such as the intrinsic value method described by James E Walter and explained much more accessibly in Valu.able, and even some for assessing risk (such as the Macquarie Quality Rating). The research necessary to even partially determine such metrics for all of the companies on the ASX (let alone internationally) with any accuracy is far beyond that available to the average retail investor, so historically we have had to only work on a handful of stocks recommended by professional researchers or investment publications, or use our gut as a first pass.
Like so many other things, the information age has turned this on its head. These days, a single service can value, and assess the quality of, the entire ASX, identifying companies worthy of further, thorough analysis. And this is exactly what products like Skaffold are useful for, and why they always come with a disclaimer.
When you make an investment, it is your cash, and your decision. You will reap the rewards if you get the risks right and pay the price if you do not. Tools like Skaffold (as an implementation of the MQR and intrinsic method) simply remove the noise, and allow you to find gold without having to pan too much gravel. When I first came across the MQR, both Forge Group and JB Hi-Fi were A1 and trading at a discount to estimated I.V. The decision to invest in the former and not the latter was not a function of luck, but an exercise in risk management.
The reason I invested in Forge was, that I know the industry, because I worked in it. I know the way high ROE is achieved in construction and mining services, the kind of businesses that can maintain it, and how such businesses generally grow. After carefully considering all of the available data and quantifying what I did not, or could not know, I felt I really did understand the risk and the potential reward, and as such made the investment.
In contrast, I did not understand how JB Hi-Fi would continue its level of growth, even in the medium term. I also work in the technology industry, and the threat to margins from online retailers was obvious, even two years ago. (This threat and the maturing nature of JBH was written about by Roger Montgomery some years ago) The discount to I.V was there, but the risk that ROE could not be maintained was too high for me. This is not a comment on the quality of JB Hi-Fi as a company, but on its valuation as a growth stock using historical ROE.
Generally, the more we know about managing businesses, the industries in which they operate and the products they are selling, the better we are at identifying and managing risks associated with these activities. If we were running the business we would be assessing strengths, weaknesses, opportunities and threats, barriers to entry, competitive advantage, brand awareness, and R&D just for starters. If we are considering about buying even a small part of a company, we should be doing the same.
In my opinion, I would rather have large investments in a smaller number of companies where I have control of the risk than rely on the brute force of diversification where I accept the risk premium of the market in general. I miss out on a lot of really good stories as a result (I don’t invest in mining exploration stocks for example) but at least I sleep well at night. My capital has been the result of far too much work for me to treat it cheaply.
There will be times when you can’t accurately assess risk, and times when no high quality stocks whose risks you understand are trading at a discount to their intrinsic value. It is times like this that it is hardest to hold your nerve. Remember, you don’t have to invest in the stock market, you can assess other asset classes, or alternatively you can follow Arnold Rothstein’s advice to Nucky Thompson (Boardwalk Empire – I recommend it if you haven’t seen it) for when the path forward isn’t immediately clear or the risks too great.
Do nothing.
Postscript:
- What is more common in Australia, suicide or homicide
- Motor vehicles are the most common cause of deaths attributable to “external causes”, what are the next 3 most likely
- What is the more common cancer in Australian women? Respiratory, digestive or breast?
Answers
- Suicide represents 24% of all deaths by “external causes” compare to 2.4% for deaths attributable to assault. While this probably didn’t surprise you suicide is also far more common in the USA.
- In order; Suicide, Falls and Accidental Poisoning (Snakes, spiders, jellyfish and crocs hardly rate a mention. There were not deaths attributable to snakes on a plane).
- In order; Digestive (4,917), Respiratory (3,080) and Breast (2,722)
Data from ABS census 2009
http://abs.gov.au/AUSSTATS/abs@.nsf/mf/3303.0/
1. van Veelen,M. and Nowak,M.A. (2011) Evolution: Selection for positive illusions. Nature, 477, 282-283, 10.1038/477282a. Available at: http://www.ncbi.nlm.nih.gov/pubmed/21921904 [Accessed September 15, 2011].
“Dividend policies and common stock prices” James E Walter
Author: Dennis Gascoigne is, or has at some time been; a Civil Engineer, Application Developer, Molecular Biologist, Management Executive and Professional Musician. He has held senior management roles in international Australian construction companies, has founded successful businesses in both civil engineering and information technology, and more importantly, played at the Big Day Out. These days he splits his time between genome research, and working on his cattle farm at Tenterfield in the NSW tablelands.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Matthew Smith
:
Great post.
I really hope more people think about risk and how best to manage it effectively whilst compounding their capital at a significant rate.
Risk is not really focused on by many investors as it is so much harder to quantify versus return. In my opinion you cant really quantify risk at all (sorry to those EMH fans)
Many people have said “but the stock is paying a dividend yield of 7%, which is such a great return” – but I would still rather earn 4.5% in cash than buy a mediocre business at a fair to overvalued price.
Marty Whitman is a champ!!
Kelvin
:
Great post Dennis. Agree totally.
Roger, I have a question tangentially related to risk. As you know, I’m a big fan of yours and think that your work is fantastic. But there’s still something that I don’t understand about your approach. When you say that, for example, a mining exploration company that has found commercial reserves in the ground but not yet in production is worth nothing, are you being deliberately provocative to make a point or do you mean it? I guess this is related to the question of whether your approach would encompass Marty Whitman’s approach of balance sheet/ asset based value investing. May be your view is that his balance sheet based approach requires a catalyst to release value and therefore is inherently more risky? Would love your thoughts on this.
Thanks a lot.
Roger Montgomery
:
Hi Kelvin,
Of course it has a value. The issue is that the market attributes a value to what is in the ground that is often higher than the present value of the business that will produce and sell it.
Kelvin
:
Thanks Roger. Just for my own education, what do you think of Marty Whitman’s brand of value investing?
Thanks a lot.
Kelvin
Roger Montgomery
:
Hey kelvin,
He’s one of the few investors I know who also believes a margin of safety exists not only in the price of a stock…(See Value.able). I deleted your link because it sent me to an Error 404 page.
Ray H
:
Hi Kelvin,
Have a look at Compass Resources (CMR). Been in administration for years now. At one stage 5 or 6 years ago it had resources with an in-ground value estimated at $6 or $7 billion (yes with a B!).
Sadly I lost a chunk of capital myself on this particular lesson.
Roger Montgomery
:
Good back up example to help make the point. Thanks Ray.
Kelvin
:
Hi Roger, thanks for the reply re Whitman above.
Hi Ray, I don’t think its that helpful to generalise from one example. Fortescue before it built its rail/ port infrastructure? There are plenty of examples either way. The key is that investing in pre-production mining companies involves application of analysis and principles no less rigorous or thorough than Roger’s methodology in valuing companies in general.
Kelvin
Bruce
:
Hi Kelvin,
I think it is helpful to remember that risk is not simply the risk of losing your money. There is also a risk of making a poor return, or of making less return on one investment compared with another. In the case of some junior miners, there is the risk of locking up your capital for many years without any return.
I have holdings in a few junior explorers, some with very substantial value in the ground and very well managed. However, there is a significant risk that even the best operators will have difficulty turning that resource into cash in an acceptable timeframe given the number of external factors which can come into play. (Having said that, I’m hanging in there :-)
Many thanks for your excellent contribution Dennis
Kelvin
:
Thanks Bruce, see my reply to Dennis’ comments below. Hope your junior explorers come good :-)
Dennis Gascoigne
:
Thanks very much Kelvin. My personal concerns with explorers is the risk associated with firming a resource, gaining approval, accessing capital for development, building and accessing infrastructure and then cost effectively exploiting a resource.
For my mind there is soooooo much risk in any one of these steps, let alone all of them, that you would need a mind bogglingly huge discount to make it a valid proposition. I have no idea how anyone can accurately value those risks.
Kelvin
:
Hi Bruce above, hi Dennis, thanks for your comments. I agree with everything you said. The truth is that most mining exploration companies have no value whatsoever. Some do, but they are few and far between. You need the right management (most important), the right project, the right commodity, the right country, the right location within that country, and the right market conditions (bearing in mind that commodities prices are by nature cyclical). All of this requires quite a bit of industry knowledge. It can be done though – that is what banks who provide project finance to the mining industry do, day in day out (although primarily from a debt perspective).
Also the discount you’d need from a project’s net present value IS massive – we’re talking about 90% or more, not 20% or 30%. And you would not put 100% of your investable funds into this sector – may be 5-20% depending on what your goals are. This is one instance where risk and return can be positively correlated. So unless an investor approaches this sector in a professional and thorough way, its gambling and not investing. But then again, every one who follows Roger on this site and his book Value.able and actually practises those principles is a professional and not an amateur……..
Andrew S.
:
Do you think the higher suicide rate in the US is due to the high level of gun access?
I think they also have a far higher homicide rate for the same reason.
Wonder whether WB has one? Bet he doesn’t!
Dennis Gascoigne
:
Andrew;
The differences in suicide rates could be genuine, maybe a function of different reporting mechanisms. If it is genuine, then I guess a guns have the advantage/disadvantage of immediacy.
I would think it could possibly have a lot more to do with opportunity, differences in equality, quality of healthcare system for the disadvantaged and active programs addressing the issue.
Nothing like good stats and a graph!
Michael
:
MQR: I haven’t heard of it before.
Roger Montgomery
:
Hi Michael,
You have been posting here since september 2010 – Are you sure you haven’t heard of it? ;-)
Michael
:
I have definitely heard of the MQR that you invented. If you read over the post above though, it has a new name for the M.
Roger Montgomery
:
I reckon that was a typo Michael.
Mick
:
With tongue firmly in cheek, I wonder if the new “QR” mentioned in a recent (name removed) Report article was a typo too?
Kudos for YOUR originality Roger.
Roger Montgomery
:
Thanks Mick for noticing. We had a good laugh here at Montgomery HQ. Imitation is the sincerest form of flattery and plagiarism the tool of the weakest competitor. More worrisome is adherence to the principles of ‘value investors” and yet talk of “growth” and “income stocks”: This as a lesson to them from Charlie Munger: “The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle. It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one adviser to distinguish himself from another. But to me, all intelligent investing is value investing.” And this from Buffett “The two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
David Sinclair
:
Hi Roger,
My initial comment appears to have vanished into cyberspace, so I will try again.
Why do you go on about there being no difference between value and growth when it appears from your comment that this un-named other group are classifying stocks as either income or growth, not value or growth? I would assume that income and growth are both components in the calculation of value, but the value of some stocks will come mostly from their current income while the value of other stocks will come mostly from future growth. While the distinction may not always be clear, income vs. growth does appear to me to be a useful concept and not at all inconsistent with a value-based approach to investing.
David S.
Roger Montgomery
:
OK. Thanks David.
Dennis Gascoigne
:
Yep, my bad. Apologies Roger, can you please correct that :)
The acronym as it currently stands would probably be an inverse measure
Michael Leslie
:
Excellent submission, Dennis. Also a great review from Andrew. All most helpful.
Andrew
:
Nice post Dennis, and thakyou Roger for allowing us and posting articles from the community.
You have prosecuted your case quite well Dennis. Humans as a whole are quite emotional animals and this can lead to our downfall some times. Another “fault” if you can call it that is that we like people to agree with us which you touched on about confirmation bias. There are so many examples where people use facts from experts that agree with them to prove the other side wrong. I think we should go back to the socratic method and always question if our beliefs are valid. I have also heard of a method of statistics where before you investigate you have to list what you think you will find before you even start.
I have put into my investment process strategies to help manage the problems you speak of. I will have pre-conceived ideas but i am aware of that in advance so that i can lay that on the table and remove it as a factor. I will then investigate if that is still true. I have been proved right and wrong on many occasions.
Even though my approach is qualitative i like to try and make the analysis as quantative as possible so that i have facts and/or figures rather than gut feel as the main decsion maker. I am also trying to make a quantative approach to measureing competitive advantage as well and the battle here has been trying to remove the confirmation bias. I think i am finally getting there with this.
Keep up the good work Dennis, i look forward to reading anything else of yours that may appear on this blog.
Roger Montgomery
:
Indeed.
Dennis Gascoigne
:
Thanks for the kind words Andrew. I really enjoy trying to analyze and understand motivations, risk and logic and investigate to what extent I can use any insights to improving my investment strategies.
I am not sure what my next post will be on, possibly a deconstruction of money supply and the impact on markets. I promise it will be more interesting than that thought bubble sounds ;)
Andrew
:
Hi Dennis,
I am sure it will be more interesting, the detail always is more interesting than the thought bubble.
I am also interested in analysing and trying to understand the thought processes and what i call “emotion” behind an investment and the impacts this can have on investors, their return and the market as a whole. It is why i really enjoy watching any episode i can of YMYC. I don’t do it for the stock tips but to listen to peoples opinions on why they bought a particular company or why they think they should sell etc.
I think the behavioural side of things can be really interesting.
Once again, thanks for the good post.