A recent post by John Hempton of Bronte Capital on a fairly well known value investor’s portfolio back in March 2008 posed the challenge of ‘risk-assessing’ the portfolio. I don’t know Mr Hempton personally but I enjoy reading his posts, he’s an independent thinker.
The post, titled “A puzzle for the risk manager“, detailed the investment manager’s stock portfolio which performed very poorly over the next 12 months. Managing assets requires continued learning and you can learn a lot by studying not only your own mistakes but the mistakes of others.
“The big difference between those who are successful and those who are not is that successful people learn from their mistakes and the mistakes of others” Sir John Templeton
This case study provides a great opportunity to think about the process of portfolio construction, human psychology and history.
Here is the portfolio:
I'll run through some of my thoughts on the portfolio and the issue of portfolio construction.
The key to managing risk is to think. There is no substitute for thinking about the portfolio and how it may perform in adverse conditions. Using screens and computer models of loss expectancy are a poor substitute for common sense and many fund managers who relied on such models learnt an expensive lesson in the financial crisis.
“The best way to minimize risk is to think” Warren Buffett
"In life as in investing, what kills you is what you don't know about and what you're not thinking about" Bruce Berkowitz
The number one risk a portfolio manager must avoid is the permanent loss of capital. So the question becomes, does this portfolio pose the risk of the permanent loss of capital?
Building an investment portfolio involves a lot more than just picking cheap stocks. It requires consideration of position sizes, industry concentration, liquidity and how the overall portfolio will perform under different scenarios including those which may not have happened before. The portfolio manager must be alert and aware of changes in the markets, economy, politics, and society at large. Changing circumstances may warrant portfolio changes.
In many cases, portfolio failure results from poor portfolio construction, a failure to recognise changing circumstances and/or the failure of imagination about what the future may portend.
A portfolio must be constructed to withstand the unexpected.
"A fiduciary should think more about the safety of an entire portfolio than about any individual holding" Seth Klarman
In assessing any portfolio, I like to think of the seven common causes of catastrophic failure - excessive concentration, excessive correlation, illiquidity, excessive leverage, fraud, capital flight and valuation risk.
Let's assess the subject portfolio on each:
Concentration: The subject portfolio has 48% of its assets exposed to the financial sector. To me this is the biggest risk as financial stocks inherent leverage make them susceptible to failure.
While Warren Buffett has invested in financials he also acknowledged the significant risks. His 1990 letter referenced his Wells Fargo investment that year...
"The banking business is no favourite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portfolio of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks."
Mr Buffett thought broadly about the possible worst case scenarios facing both the banking sector and Wells Fargo. Only after concluding such a worst case outcome would not 'distress him' did he invest.
"Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable. None of these eventualities can be ruled out."
Buffett noted at the time..
"Buying into the banking business is unusual for us.. but opportunities that interest us and that are also large enough to have a worthwhile impact on Berkshire's results are rare. Therefore, we will look at any category of investment, so long as we understand the business we're buying into and believe that price and value may differ significantly."
The key point Mr Buffett makes here is "understand". The issue confronting investors prior to the financial crisis was that the banking industry had become increasing complex and opaque. Innovation in capital markets had seen credit markets grow feverishly as banks securitised significant quantities of assets, increasingly relied on wholesale funding markets as opposed to deposits, played in credit derivatives and placed excessive trust in ratings agencies. The global banking industry had become far more entwined and far more susceptible to fickle credit markets.
“Complex systems are full of interdependencies—hard to detect—and non-linear responses. In such an environment, simple causal associations are misplaced; it is hard to see how things work by looking at single parts. Man-made complex systems tend to develop cascades and runaway chains of reactions that decrease, even eliminate, predictability and cause outsized events. So the modern world may be increasing in technological knowledge, but, paradoxically, it is making things a lot more unpredictable.” Nassim Taleb
"The condensation of credit cycles and the increasing incidence of credit dislocations is a consequence of the globalisation of the world economy, technological advancements in the electronic transmission of information, and financial innovations such as derivatives and securitisation that blur the distinctions among markets and asset classes. The confluence of these developments has perversely made the markets more informed but less informative. Information and capital rocket around the world at unprecedented velocities and volumes, leaving investors to process market data before reacting. Today, a pin dropping in Argentina can cause simultaneous ripples (or waves, or in rare cases tsunamis) as far away as Japan. By the time the pin drops, it may already be too late for investors to protect their capital. In a financial world dominated by innovation and new products that blur the traditional distinctions between debt and equity, disruptions in the credit markets are certain to affect all hedge fund strategies in all asset classes. The increasing frequency and severity of extreme credit events points to the heightened risk of contagion among markets and asset classes. " Michael Lewitt, 2003
It's hard to see how an investor could have had a reasonable understanding of the risks sitting on the books of many of the global banks. Increasing reliance on credit markets posed risks, even for those banks with large deposit bases. An investor with a generalist mindset and an appreciation of credit markets would be mindful of the potential for capital destruction in the sector.
"The analysis of credit cycles involves an understanding of