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?

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