What do we mean when we say that an investment is risky? Do we mean that we have a good chance of losing all of our money, or part of our money? Do we mean that the investment will fluctuate in value? Do we mean that things we cannot anticipate or control will impact our investment in ways we cannot anticipate? Understanding risk is an important part of the investment process, and a very important part of our job as portfolio managers.
At the outset, we should differentiate between investment risk and speculative risk. If a person bets black or red on the spin of a roulette wheel this is not an investment. It is a speculation. The ball will randomly stop in red about half the time, and about half the time, the gambler will in short order lose all his money. Certainly there are stocks on the stock market that perform like a roulette wheel. These are primarily small mining and energy ventures which speculators hope will find gold or oil and make them rich. More often than not these companies simply dissipate shareholder funds and go bust. In our view the purchase of shares of companies like these is not investing; it is simply another way of gambling.
In contrast, the purchase, after thorough analysis, of the shares or bonds of a well established company with a track record of revenues and profits is the essence of the investment process. Many things can and will impact the success of such an investment, but pure chance is only one of them, and in most cases, plays a relatively minor role. Unlike the spin of the roulette wheel, the results from an investment are determined over time, sometimes a long time, and are much more nuanced. Rather than red or black, investment outcomes span the spectrum from very successful to abysmal, and everywhere in between.
Even the most thorough analysis and smartest selection process cannot remove all the risk elements in the investment process. Risk arises in a number of ways. Some risks are calculable and can be guarded against. Others are essentially random and can be neither predicted nor fully hedged. A hierarchy of risks is detailed below, and in each case the nature of the risks and the ways in which they may be addressed is described.
Just as we accept the risk of random events such as car accidents and illness in our non-economic life, we have to live with the reality of unexpected crises in our economic life. The catastrophe of September 11, 2001, demonstrated that even the most carefully constructed portfolio will be affected by unpredictable events. These can include terrorism and acts of war, outbreaks of disease and disastrous weather and geologic occurrences such as the tsunami in Japan in March, 2011. While it is, by definition, impossible to plan for exogenous risk, experience shows that a diversified portfolio withstands this kind of problem much better than one that is concentrated in a single or a few asset classes.
Records show that the stock markets took tremendous hits after the assassination of John Kennedy, after the start of the first Gulf War, and after 9/11, but in all cases bounced back within three to six months. Similarly, Hurricane Katrina in 2005 and the California earthquake of 1989 had only short-lived impacts on the financial markets. In most cases the market shocks arising from exogenous risk are sharp but short, and mostly hurt those who sell in panic.
In October, 2008, the world banking system came close to failing. Only concerted action by the central banks of the world’s largest economies prevented what could have become a major collapse. While the risk of a systemic failure of the entire banking system or of a major stock market is small, clearly it is greater than zero. Of more importance is the emergence, from time to time, of systemic failure in part of the market.
While we prefer to believe that markets are always rational, clearly this is not the case. A good example is the U.S. housing market six to eight years ago, where speculative buying and cheap mortgages moved prices up to unsustainable levels. The subsequent crash was a major cause of the stock market crisis and world recession that followed. The dot com bubble of 1998– 2000 caused the NASDAQ index to rise to 5,132 in 2000; it quickly fell to 1,108, losing 78% of its value over the next 30 months. Both of these market failures exposed investors to substantial risk, and in many case, real losses, and are examples of systemic failure.
The best defenses against systemic risk are fundamental analysis and a staunch refusal to follow the herd. For example, research demonstrates that when house prices rise much faster than incomes, those prices will fall as houses become unaffordable. The rational investor will avoid the temptation to invest in this “hot” sector that clearly must correct. During the tech stock boom, all traditional measures of company worth were abandoned in an attempt to justify stratospheric prices for small and untested companies. Those who relied on time-honoured valuation techniques were not hurt by the crash.
Even the most recent stock market crash, which saw prices drop by 50% from September, 2008 to March, 2009, did not result in losses for investors in fundamentally sound stocks. Shares of the Royal Bank, for example, dropped in half over seven months, but recovered all the losses (and more) within a year. The same can be said for other leading companies such as BCE and Transcanada Corporation.
Investment returns will be affected by economic conditions both in Canada and in the rest of the world. In a recession, corporate profits fall, and as forward earnings become less predictable, the market may pay less for the future, resulting in a contraction of multiples of price to earnings and price to book value. When times are good, both earnings and multiples tend to expand, leading to sharply higher share prices.
Prudent portfolio managers devote considerable time and energy to tracking the macroeconomic environment in order to avoid being blind-sided by events. When it is apparent that interest rates are rising, for example, managers can shorten the duration and average time to maturity of bond portfolios. When the economy seems to be losing steam, equities that are more sensitive to the economy can be switched for those that are generally more recession-resistant. While no one has a perfect forecasting record, much of the economic risk can be dealt with by proper portfolio diversification and timely movement of funds. While short term “market timing” is impossible, long term economic risk management is not.
Industry Specific Risk
Business conditions within industries can vary sharply from overall economic conditions. While car sales, for example, closely follow economic cycles, prices for commodities such as oil and gold move to different rhythms which may be very different from the economic cycle. As with economic risk, industry risk cannot be predicted with perfect accuracy. However, through constant monitoring the careful portfolio manager can usually see signs of trouble before they become critical. By moving into or out of sectors as conditions change, much industry specific risk can be avoided.
Company Specific Risk
Great companies can surmount poor industry and economic conditions. Poor ones cannot thrive even at the best of times. The most obvious and basic job of the portfolio manager is to distinguish between the two extremes and to invest in those companies that will produce wealth for their shareholders. Companies that are out-and- out frauds, although rare, can usually be spotted through exercise of caution and diligence.
We believe that much company specific risk can be avoided by investing in companies with a history of profits, proven management and a solid financial position. Use of fundamental financial statement analysis is the starting point for company selection and eliminates many potential mistakes if rigorously applied.
We also recognize that great companies are not always great investments, since the price at which the investment will be made will have a large impact on the eventual return. Refusing to pay too much, even for a good company, is part of the discipline of portfolio management.
Risk is an unavoidable part of life, and an unavoidable fact of investing which every investor much accept. Recognition of the origins of risk is the first step to controlling it.