Understanding Investing Risk
Posted on | March 9, 2010 | No Comments
What is investment risk? Wikipedia says there are two types of investment riskless and risky. I will start by disagreeing. It is a subject I have written about before in Does a Risk Free Rate Exist? My answer to the posed question is no.
I have meant to post on James Montier’s concept of investing risk ever since I first read Montiers writings. He gets risk in a way that the uber-smart quants sometimes fail at. He recognizes that risk is not an equation or number, it is a concept. Much of this post refers to his Clear and Present Danger; The Trinity of Risk, but I will refer to other of his writings as well. You really should read Montier directly.
For anyone who follows in the Graham school of investing, or this blog, you know that first and foremost is preservation of capital. Montier begins in this tradition, “Graham saw risk as the Permanent loss of capital.” Amen. We as investor’s often spend way too much time chasing the return and not examining the downside. That is the risk.
Montier divides investing risk into what he calls the trinity.
The first aspect of this trinity is valuation risk. Simply stated the risk that you will screw up the valuation of a company and over pay for the stock. Montier says, “buying expensive stocks leaves you vulnerable to disappointment.”This is classic value investing. Don’t overpay. There are lots of metrics to keep things cheap.
Montier suggests that we should return to works of Graham and make sure we are not buying a stock with a P/E greater than 16. He quotes Graham, “We would suggest that about 16 times is as high a price as can be paid in an investment purchase of a common stock? Although this rule is of necessity arbitrary in its nature, it is not entirely so. Investment presupposes demonstrable value, and the typical common stock’s value can be demonstrated only by means of an established, i.e. an average, earnings power. But it is difficult to see how average earnings of less than 6% upon the market price could ever be considered as vindicating that price.”
The second aspect of the trinity is business/earnings risk.
Again Montier defines the term by quoting Graham, “Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.” When a company suffers an earnings drop, or an outright loss the price of the stock can drop substantially.
The trick in assessing Earnings risk, is to figure out whether or not an earnings set back is temporary or permanent. If you get this wrong you will end up with a value trap instead of a good deal. Again Montier has a metric. Instead of just looking at Price Earnings alone, he suggests that you look at the ratio of P/E to the ten year average P/E. To minimize earnings risk this ratio should be less than two, perhaps considerably.
The third of three is Balance Sheet/Financial Risk. Montier again uses Graham to define, “The purpose of balance-sheet analysis is to detect? the presence of financial weakness that may detract from the investment merit of an issue.” According to Montier most investors are smitten with earnings and only look at balance sheet risk when something goes awry. Obviously, with the emphasis on NCAV stocks on this, we often start with balance sheet risk.
Montier uses a metric that readers of this blog will recognize, the Altman Z score. Interestingly, he uses the standard manufacturing equation in his evalution, but I will tweak Montier, if I may, and refer to the non-manfuacturing Z-score.
T1- Working Capital/Total Assets
T2- Retained Earnings/ Total Assets
T3- Earnings before Interest and Taxes (EBIT)/ Total Assets
T4- Market Value of Equity/Book Value of Total Liabilities
T5- Sales/Total Assets
The revised Altman Z score is Z= 6.56T1+3.26T2+6.72T3+1.05T4
The score should be above 2.6 for non-manufacturing, non financial companies to minimize balance sheet risk. If it is below 1.8 watch out. For manufacturing companies refer to the original Altman Z score.
Now you can put all this together. But ultimately, Montier sums up best when he argues “that risk is really a notion or a concept not a number. Indeed the use of pseudoscience in risk management has long been a rant of “(his).
Look at a range of factors that make up investment risk and take appropriate action.
What do you think comprises investment risk. Am I missing anything?
Simoleon Sense interviews James Montier
Posted on | March 8, 2010 | 2 Comments
My friend Miguel at Simoleon Sense has conducted another one of his terrific interviews. This time it is with James Montier, who is always someone worth listening to. I have written previously about Montier’s perspectives before. You can check out Montier bitch slaps EFH or Good Decisions, Bad Outcomes. He hails from the behavioral Finance camp, which it is safe to say, the right team to be on.
I think he gets investment risk better than any one. I will quote two passages, the first lays it out, “Modern risk management is a farce; it is pseudoscience of the worst kind. The idea that the risk of an investment, or indeed, a portfolio of investments can be reduced to a single number is utter madness. In essence, the problem with risk management is that is assumes that volatility equals risk. Nothing could be further from the truth.”
The second is where he talks about his trinty of risk which I would like to devote a whole post to in the near future, “…I don’t think of risk as a number, but rather as a permanent impairment of capital (as Ben Graham put it). Now that permanent impairment can be generated by three potential sources (which aren’t mutually exclusive). Firstly, there is valuation risk – you can simply overpay for an asset. Secondly, there is fundamental or business risk – something goes wrong with the underlying economics of the asset. Thirdly, financing risk or leverage (which no matter how hard you try can’t make a bad investment good, but can make a good investment bad).
I’m not sure that any of them is easier or trickier to monitor. I think you to consider all three aspects in order to gain a holistic view.”
Enjoy the first part of the interview.
Lessons Learned from Mike Burry
Posted on | March 4, 2010 | 4 Comments
Hat tip to Greenbackd for the following link to the Vanity Fair article that is an excerpt from the book The Big Short: Inside the Doomsday Machine by Michael Lewis, which has not yet been released.
Burry was the guru behind Scion Capital. He was a great stock picker and later made $100 million buying credit default swaps, investing against the housing bubble.
I am not going to recount the article. Read it if you are interested in what great investors do. It is a great read. I am just going to share with you the what I take away from the article.
1) Do not Follow. That means Warren Buffett, Seth Klarman or Mike Burry. You must come up with your own investment stategy. It has to work for you , if you want to be successful. Understand the principles of Ben Graham, but don’t be a slave to his ideas. “To succeed in a spectacular fashion you had to be spectacularly unusual.”
2) Use your differences to your advantage. Burry felt he was different because he only had one eye (although it turned out not to be his real difference). That is a good metaphor for most investors. We are all a little different. Understanding our differences and utilizing it to our investing advantage is imperative. I know this sounds a little self-helpy, but what the hell.
3) Bargains are found in the discard bin not on display at Tiffany’s. To be a value investor you must keep looking when others give up, or don’t understand something. Use your understanding of an industry, or circle of competence to your advantage. Burry referred to the “ick” factor. That is he ended up buying stocks of companies, where his initial reaction was “Ick.” But subsequent research revealed a value opportunity.
4) Never stop expanding your circle of competence. Burry taught himself investing. He taught himself about bonds, then the securities that were packages of subprime loans. He went where others simply did not tread, either because it was two difficult to understand, or assumed that since all the smart people were creating these issues, that betting against them was not a good idea.
5) don’t be afraid to short. I am of course not referring to actual shorting of a stock. Too much risk. But Burry found a way in Credit Default Swaps (CDS) to invest against the mortgage bonds.
6) just because someone tells you an investing idea is bad, even if they can articulate why, doesn’t mean you shouldn’t invest in it. Some investors like Monash Pabrai like to attach probabilities to an investment. If the probability of success is high, make a larger investment proportionally. I won’t call it probability, because I don’t believe anyone can accurate assess the probability of success in the investing world. There are simply too many unknowns. But that does not mean we cannot assess whether or not our investment thesis is stronger than another investment idea.
7) Don’t get emotional about your investments. I have stated this before on this blog. But it is always worth remembering and I am reminded of it from Parker’s comment.
If you read the Vanity Fair article, please let me know if you culled something interesting that I missed, particularly if it was really obvious.
Tags: Investing Strategies > Value Investing
Easy Concept, Potentially Profitable Investing Strategy
Posted on | March 2, 2010 | 2 Comments
This is really another in the Value Investing Series, but also an 80/20 Investing idea. To reiterate 80/20 investing is my value investing concept that attempts to get 80% of a solid return with 20% of the work. Not sure if it is really viable, although I am thinking of starting a test portfolio. But it is also the result of finding the website I mentioned in yesterdays blog about Empirical Finance Research.
The important distinction between Value Investing and speculating is that Value Investing involves research, and some analysis. Mostly, it is about properly valuing a company and buying at a discount to intrinsic value. Speculating requires you guess the correct direction of a market, stock or commodity. Within that statement I am not sure that this concept actually falls within the simple concept of value investing I just laid out. The paper is called The Asset Growth Effect in Stock Returns by Cooper, Gulen, and Schill. You should read it. It is not hard to follow. And they do a better job than I do of explaining their own findings. However for the 80/20 people…
Here is the concept: take all non financial, US stocks and look at their growth in assets, Total Assets( t)- Total Assets( t1)/ Total Assets (t1). Then you arrange then in deciles (10% groups) from highest to lowest. The lowest deciles of Asset growth stocks beat the highest decile by more than 20%/year. This equals a return of 23.28%. Not too shabby. But this is another typical value investing idea that is sort of like Einstein’s theory of relativity. The more you explore the more it defies the world that you know. This research seems to imply that hi ROA companies are likely to experience sub par returns while low ROA companies will likely have outsized returns. Isn’t that contrary to everything we learn in Investing 101? But if you look at Table 1 of the study, the high asset growth companies have an average ROA of 21%. Sounds great, right? The low asset growth rate stocks averaged -3.1% ROA.
There are actually a couple of problems for the practical investor. First, the strategy seems to require a relatively large outlay of stock purchases, which is simply not feasible for the small time investor. If you are required to buy 10% of the stocks evaluated that is hundreds and hundreds of stocks. Second, the What is wrong with Back Testing phenomenon is also important to take note of here. Any back tested concept that requires a specific purchase date and rebalancing time frame, has the potential to buy and ineffective or unprofitable times, when a less inflexible model might not. But who knows. I am still reeling from the concept that low ROA may be good.
An aid to Empirical Finance Research
Posted on | March 1, 2010 | No Comments
I am a fan of empirical evidence that supports investing strategies. This sounds like an obvious statement, but many people don’t care, or at least that is how seems if you view their actions. I have previously highlighted evidence that could potentially enhance returns like Low price to book, and help protect against loss like the Altman Z score.
I have discovered a blog that sifts through Finance Studies to look for papers that can help with investing. The blog is called the Empirical Finance Research Blog. While it may sound dull, it is actually a terrific resource. The writer reviews financial papers and then evaluate them for practical investing on a scale of 1 to 10, 10 being the best. He also lays out his proposed investment strategy based on the research. One of the best aids I have found. I have one complaint. And it is selfish. The blog posts irregularly. His last post was from January.
Tags: Investing Links > Investing Tips
Endwave (ENWV) an update
Posted on | February 27, 2010 | No Comments
I posted on ENWV back in December when they had the illusion of a Net Net stock with a margin of safety. But it was all in the details. They had a slog of Preferred shares that weighed on the balance sheet. They were losing money, and seemed to have a lot of unhappy shareholders. There have been some changes since and I wouldn’t want anyone to be stuck with my previous assessment as the only look at the company. I still don’t own any shares. I am still on advocating buying ENWV, but the situation has changed enough to make it worth looking at least.
In January ENWV bought back all the preferred shares from Oak Investments for $36 million. This was discounted from Oak’s original Investment by $9 million. This was a huge step in the right direction for shareholders for two reasons. First, it took the slightly submerged overhang of the preferred shares off the books, and at a discount. But more importantly the company is not beholden to Oak any more. This frees the company to be acquired by another company. That is not a prediction. But another company did not really have the option prior to the buy out of the preferred shares.
Since then, a whole lot interest has been paid to ENWV. On 2/8/10 Dimensional Advisors disclosed a 7.8% position in the company. On 2/10/10 Portolan Investment disclosed a 4.3% position in the company. On 2/16/10 Potomac Capital disclosed a 6.19% position. Empire has also increased its holdings, although some of that may have been a year end loss, and repurchase after 30 days. In any case, if you are the type of investor that likes to see other investors buying, then you would like this news. I am only interested in what investors I respect are doing, or company officers. Nothing in the 13G/A’s to indicate management is interested in their own stock.
I estimate their current NCAV value at $3.19- $3.52, depending on how you calculate it. Taking the Graham Margin of Safety of 33% gives you a purchase price somewhere around $2.32 on the high side. The shares closed yesterday at $2.60/share. But if you are willing to take a smaller margin of safety you might be interested. But I would caution you as always to think twice before making any investment. Do your own research. Double check everything. Since ENWV is still losing money on operations of $3.4 million per quarter, as reported in their latest 8k, ENWV still seems like a risky proposition to me.
Margin of Safety – Beginning Investor Terms
Posted on | February 24, 2010 | No Comments
Margin of Safety is a concept I write about a lot. It is the make or break for any investment. While I may fudge the amount from time to time, all investments have to have a margin of safety to be worth shelling out my cash. But what is a Margin of Safety?
It is a term that Benjamin Graham and David Dodd coined in their seminal book, Security Analysis. First Graham began with the idea of intrinsic value. Or how much a company is worth (in opposition to how much it costs). If the price of a companies’ share is lower than the intrinsic value of that share then the difference is a margin of safety. Graham argued for a minimum margin of safety of 33%. More is better, but harder to find. The purpose is to protect an investor in case some part of your analysis in determining the intrinsic value is incorrect, or to help protect if the market or luck turns against you.
In a recent example VOXX, my NCAV value was $9.82/share. By my reckoning this would be VOXX’s intrinsic value. The price when I bought VOXX was $6.60/share. This gave me a Margin of Safety of about right under 33%. Any questions? Please post in the comments or email me chroma@chromainvesting.com
Tags: Beginning Investor > Investing terms
New Beginning Investing Blog – The Fallible Investor
Posted on | February 23, 2010 | No Comments
I came across a new investing blog that I think is terrific for beginning investors. It is the Fallible Investor. The writer is an Australian value investor who shares a lot of the same tastes as I do: Taleb, Montier, Klarman. I particularly like his concept of laying out scenarios for a business, good and bad and then describing the pros and cons of those scenarios. Even in a Net Net stock we need to look at the downside. Sure we may be protected by a margin of safety, but was is the likely scenario if everything goes south. IF liquidation is the likely outcome, have we really adequately calculated liquidation expenses and more importantly, would the liquidation be forced or as Klarman discusses “an orderly” liquidation. Each of these different scenarios effect the range of valuations. Also, what if our investment does better than expected? Having thought about the upside can help lead us to a better exit strategy.
The Fallible Investor recommends reading his posts from oldest first to get a sense of his investment philosophy. Enjoy!
Clarus (CLRS) a NCAV stock – is it worth investing in?
Posted on | February 22, 2010 | No Comments
Shadowstock posted this analysis of Clarus (CLRS). It is an interesting idea.
CLRS is essentially a shell company with Net Current Asset value of approx. $4.78/share. All its assets are either cash or short term investments. At its closing price of $4.45 today, it is trading at a small discount to its NCAV value.
I first looked at CLRS about a year ago, when the Net Asset value was a little better and the stock price was lower. I never pushed the button on the stock, because it seemed that Kanders (CEO and major investor) had a fair amount of time back then to make an acquisition, but had failed to do anything except burn cash. The Net Operating Lossess (NOL) will continue to expire each year and there is a small cash burn while nothing is going on. I do not know how one evaluates or values NOL’s, so I cannot confirm or deny Shadowstock’s estimates of $1.30/share.
While there is some small downside protection, on an asset valuation, everything else about the company seems speculative, including what type of business it might acquire or whether or not it will acquire another company at all. Since it is neither profitable nor does it have a sufficient margin of safety, CLRS is a pass for the moment.
Does a Risk Free Rate Really Exist?
Posted on | February 18, 2010 | No Comments
I was perusing Musings on the Markets, Damodaran’s blog and came across a post entitled Thoughts on the Risk Free Rate. Perhaps, because I am not an academic, I usually reject ideas that seem contrary to logic or that seem designed for an academic and not practical use. The Risk Free rate is one of these notions. This is of course not a reflection on Damodaran’s work. I am a fan. The concept of the risk free rate does not originate with him. It seems to be part of the whole Modern Portfolio Theory bag of tricks. And although it is used as a basis for the Black Scholes option price model and for calculating the Sharpe Ratio, I do not think the risk free rate actually exists. It is a theoretical construct that enables people to compare rates of return, on a theoretical risk adjusted basis. As I have written before, I am not interested in theoretical returns on my capital, but real returns.
What is the risk free rate? It is the rate of return that you can get without any default risk, that would be guaranteed for certain period of time. Investopedia says, “In theory, the risk-free rate is the minimum return an investor expects for any investment because he or she will not accept additional risk unless the potential rate of return is greater than the risk-free rate.” Ordinarily, in the United States our 3 month government t-bills act as the risk free rate, according to Investopedia.
I prefer not to divorce myself from the concept that long tail or Black Swan Events are always possible, if unlikely. By definition, risk cannot be assumed away in the real world, without ignoring unlikely events. I like them to be included in all my thinking. It forces me to always think of the downside. I am fairly risk averse. I look for a margin of safety, because I am likely at some point, to be wrong, or not have analyzed some aspect of an investment correctly.
In a post on Investing Risk, I laid out a couple of ideas concerning investment risk, including the concept that there are some risks that we may not know, or anticipate. Because we are unaware of a risk does not mean it doesn’t exist. That is the problem with risk free rate, it assumes away the unknown, or unknowable. That does not mean risk has disappeared, just that we are ignoring it.