Chroma Investing » Risk

Caution ahead – Seth Klarman’s worried

chroma — Fri, 29 Oct 2010 00:34:13 +0000

I just reread this May interview that Jason Zwieg did with Seth Klarman the hedge fund manager of Baupost Group. I have been spending a lot of time pondering fat tail risks and worse case scenario investing. Mr. Klarman’ s view more eloquently encapsulate some of my own views so I will simply include the link so you can download the whole interview.

Why should you care? This one statement says it all. ““I am more worried about the world, more broadly, than I ever have been in my career.” That’s because you can make good investing decisions and still end up with bad results if you reap your profits in currencies that do not hold their purchasing power, he explained. ”

If you want to read more follow this link. Jason interviews Seth. It is this kind of thinking that has me worried that even gold bugs like Peter Schiff may be on to something.

Fat Tail Risk and James Montier

Is Wealth Destruction Inevitable?

chroma — Thu, 09 Sep 2010 18:43:09 +0000

This posting is really a follow up to a thoughtful response I received from Parker Bohn, one of my readers, to my post Worse Case Scenario Investing. Here is his part of his comment,

“…I’ve been thinking about the nature of exponential growth and disasters.

Let’s say that after inflation and taxes, you could in the long run get a 1.5% annualized return on your investments…

Now let’s take this to the extreme, and say this wealth compounded for the extreme long-term.

2000 years looks good to me. At 1.5% per annum, $1 becomes $8.5 trillion.

Of course, I don’t expect to live 2000 years, but this is such an absurd result, that the only possible conclusion I can come to is that even 1.5% is an unsafe assumption for long-term compounding.

My hunch is that the exponential curve would be periodically destroyed by disaster.
currency collapse, totalitarianism, genocide, plague, extinction of the human race, you know, stuff like that.

But how often can we expect one of these events to take place? Once every 500 years? Once every 100 years?”

That is some stress test!

In the extreme nothing human endures. 2000 years ago the Roman Empire dominated the Mediterranean world. A safe bet was that they would rule for two thousand years because they so completely dominated the financial and political world of their time. It seemed, using Buffett terminology, that their moat was unassailable. And it was for a while. But not two thousand years, only 500 years more or less.

The United States as the dominant financial power is unlikely to survive even another century without cataclysmic economic or political events. If anything, the inevitability of wealth destruction has increased not decreased in the past century. And the increasing interconnectedness of today’s financial markets speaks to the increasingly complex notions that must be used to protect wealth in extreme events. Nobody should buy and hold forever, even if it works in one generation, it will almost certainly not work in the next generation. Flexibility and adaptability may be the only way to preserve wealth over the extreme long term. Rule number One is after all do not lose money. We don’t need to look at 2000 years to achieve the extreme long term. 100 years seems sufficient.

Of the original Dow Jones industrial average only one company, GE, is still a functioning independent company. Thus the odds of a buy and hold philosophy are not good in the extreme long term even if that extreme is only 100 years. We have had a pandemic, two World Wars , the Great Depression and lately the Great Recession in the last 100 years. All wealth destruction events. It seems to me that No generation survives without some catalysmic financial event, even if it is not as destructive to humanity as war or pandemic.

It also occurs to me that part of why Parker has identified the absurdity of steady long term accumulation is that there is simply no way to win every year in investing. For example, if you have a nasty bout of hyperinflation, you are unlikely to earn excess return of 1.5% on top of the ever diminishing buying power unless you are leveraged. On the flip side in an extreme bout of deflation any substantial debt, say a mortgage, can sink most investors. It is simply not possible to be hedged for all disaster contingencies and still make a return.

The old adage comes to mind, the market can remain irrational longer than we can remain solvent. I think there is a corollary to the fat tail risks looking forward. The markets may be rational, but that may not help you preserve your capital in the long run. I do not know if wealth destruction is inevitable but I do know that longer you invest the greater the likelihood that you will be exposed to a fat tail, or extremely unlikely, wealth destruction event.

Worse Case Scenario Investing

chroma — Sat, 31 Jul 2010 05:05:33 +0000

I have just finished reading a book that has forced me to reconsider how I evaluate risk , because it discuss investing in a worse case scenario.

Evaluating risk has been an ongoing interest of mine because I assert that understanding risk is crucial to making sound investments. If you overlook an element of risk then you may be exposing your capital to loss that you have not foreseen. Or, if your investment is successful, you may be underweighting the contribution of luck to your success. I have been a fan of people like Nassim Taleb the author of the Black Swan and Fooled by Randomness and James Montier because they helped we reshape my ideas about risk.

The book I have referred to in my opening is Wealth War & Wisdom by Barton Biggs. In essence it discusses the idea of maintaining wealth in one of the big black swan occurrences of the last hundred years, World War II. The book spends a lot of time on the history of World War II and weaves the ups and downs of financial markets into his tale. Biggs also spends considerable time attempting to prove, but not quite succeeding, that the wisdom of markets is smarter than experts and world leaders. While I enjoyed the history and history of the markets during this apocalyptic time, I was most impressed with how he details that preserving wealth in time of war and upheaval is difficult at best. There are very few ways to preserve wealth let alone grow it.

How do we look at the potential of a great upheaval and its effects on our investments. Most people simply do not take into account.. Before you say that it is unlikely we will face such difficult circumstances, remember that apart from a few very smart people, most investors did not anticipate nor profit from the Great Recession we have just experienced. It seems to be our nature to under prepare for extreme events.

Biggs offers a few important ideas in his conclusion, some of which I subscribe to and some I do not. He asserts that the long term track record of equities favors a larger investment in them than other asset classes. In fact, he suggests that you invest 75% of your assets in equities, favoring index funds. He discusses the value of real estate and in particular farm land or ranch land as place that holds value but can also become a worse case scenario place to survive if the apocalypse hits your neighborhood. This farm should not be more than 5% of your wealth. He also suggest that you have to diversify your assets outside of your home country. That when the shit hits the fan, things turn quickly and we can often not get out of the way of the shit storm.

I don’t have many answers just questions that you need to consider. After all, the markets can be irrational longer than we can remain solvent. So being fully prepared for all contingencies is simply not possible. What will you prepare for and how is something worth considering. Below I have listed a few of the ideas that intrigue me as distinct possibilities, however remote. I am stating them with as a question. Perhaps, I will return with some answers later, perhaps you have some ideas to contribute. It is difficult to anticipate what the next Black Swan will be and what the unexpected consequences will be from that event.

What would you do to hedge against hyper inflation?

How about deflation?

What if we had an incidence of nuclear terrorism, that shut down a major country?

What if there is a double dip recession?

What if there is another financial panic?

What would happen if a major trading partner, say China, suffered a crippling natural disaster?

What if a sovereign debt crisis destroyed a major currency?

What if the price of real estate dropped another 50% from here?

What if headline unemployment rises to 15%, or higher?

What if a cataclysmic event shut down much of the internet?

What if there really is a worldwide pandemic?

What if there is a major war that destabilizes a part of the world?

What if there is a major disruption in oil supplies in the middle east?

What if the Mayans were right and 2012 is an apocalyptic year? O.k. maybe not this one.

Understanding Investing Risk

chroma — Wed, 10 Mar 2010 05:15:28 +0000

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

chroma — Tue, 09 Mar 2010 01:33:06 +0000

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.

Does a Risk Free Rate Really Exist?

chroma — Fri, 19 Feb 2010 04:51:14 +0000

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.

Investing Risks – What is Risk?

chroma — Fri, 29 Jan 2010 06:13:20 +0000

Looking at the risks of an investment is vital to understanding whether or not it is a sound investment. In a speech Alice Schroeder, author of Snowball, said that Warren Buffett starts his examination of a potential company by looking at the risks involved. If the risk is too high, he won’t go any further. He literally stops looking at the investment. Examine the risk first then proceed. It is the opposite of what most of us do. We would be wise to follow this example.

But what is risk? Risk is not the same thing as volatility, although volatility is often used synonymously with risk. I like Ben Graham’s idea of risk which is, “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.” The thing to be concerned about is any permanent loss of capital.

The focus of this blog has been on value investing strategies and to help people find a manner of investing that works for them, that will, hopefully, also minimize risk. Because it is such an important topic I will return to this theme off an on. I think to many people ignore the risks when investing. This is a reminder to never forget that their always risks, some of which are unaware. Although he was mocked for it at the time, the following statment by Donald Rumsfeld is worth pondering, “As we know, there are known knowns. There are things we know we know. We also know There are known unknowns. That is to say We know there are some things We do not know. But there are also unknown unknowns, The ones we don’t know We don’t know.” Beware of the unkown, unknowns.

Chroma Investing » Risk

Caution ahead – Seth Klarman’s worried

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Is Wealth Destruction Inevitable?

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