Moerus Capital investor memo titled, “Perspectives on Risk: How You Can Lose Money – Let’s Count the Ways!”
Introduction: Risk - It Comes With the Territory
Investing, as many of us have unfortunately come to know well (with the “war stories” to prove it), is far from foolproof. It is an inherently risky endeavor in the sense that any investment, no matter how well thought out the thesis and no matter how attractive the future prospects seem to be, requires an investor to accept some degree of risk. The degree of risk that is accepted by an investor may vary wildly from extremely low to extremely high, depending on the nature of the specific financial asset and the circumstances surrounding it. Investments in very short-term United States Government Treasury bills and FDIC-insured bank deposits, for example, are generally and conventionally considered low risk and reside on one end of the risk spectrum per “prevailing wisdom,” whereas other investments in, or perhaps more appropriately worded in this case, bets on highly speculative and risky securities such as microcap penny stocks, for example, reside on the other end. Most assets fall somewhere in between those two extremes, but the point is that every investment, by its nature, includes some degree of risk, simply because nobody knows with 100% certainty what tomorrow, let alone three years from now, holds for any given investment.
Alas, the future is uncertain. We’d bet that watching ten minutes of the evening news or casually thumbing through your preferred daily newspaper would be more than enough to fill you with anxiety, dizziness, nausea – you name the reaction, but it’s likely unpleasant. Yes, it is obviously true that investing has, on average and over most timeframes, proven far more lucrative than not investing at all; if it didn’t, why would anybody invest? Still, that fact probably has not provided much consolation to anybody who, for example, was heavily invested during the run-up to the 1929 stock market crash, in Japan in the late 1980s, or in U.S. subprime mortgage-related securities prior to 2008 and the onset of the Global Financial Crisis. In each of these as well as many other cases throughout financial history, extended periods of prosperity morphed into excessive optimism, the belief that “this time is different,” the irrational overpricing of stocks, and the gross underestimation of risk. As you know, none of those stories ended well.
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A prudent, level-headed assessment of downside risk is essential to the long-term success of any investment program. Debacles such as the three listed above are debilitating to the long-term returns of any and all who are heavily exposed at the time the bubble inevitably bursts, often impairing the wonderful process of compounding by which investments grow in value over time. It might take years or even decades for an investor caught on the wrong side of a bubble to recover; Japan’s TOPIX and Nikkei-225 Indices, for example, have failed to come near revisiting their December 1989 peaks in the 26-plus years since. Although prolonged bull markets may occasionally seduce some investors/traders into thinking otherwise, the future is uncertain and risk is ever-present, perhaps most so at the very times when risk is perceived by many to be lowest.
So how do we grapple with this inconvenient truth and invest anyway, in spite of the uncertainty that the world brings? We certainly do not have a crystal ball in our office here at Moerus and because of that, we do not spend much time attempting to forecast and predict the future. Instead, we cope with investing’s inherent uncertainties by spending an awful lot of time thinking about risk in its various forms, and how to mitigate its presence in our investment portfolios. In truth, we believe that uncertainty should not only be coped with, but also embraced as a source of opportunity to invest in well-financed assets and businesses at prices that we think are compelling relative to underlying, intrinsic values. But how do we think about risk, and how do we strive to mitigate the impacts that risk has on our investment portfolios?
A Roadmap of Risks
Fair warning! In the following pages, we hope to dwell quite a bit (some might say excessively) on what risk means to us at Moerus, and how we think about mitigating its presence in our investment portfolios. When it comes to risk as we view it, there is unfortunately a lot to talk/write about – numerous factors lurking in many different areas that can cause any investor to lose money in a hurry. The road to attractive long-term investment results is littered with investing’s version of land mines, some better concealed than others, which can blow up portfolios. The successful avoidance of a few, or even most of them could nonetheless be rendered a moot point for investors who stumble upon one that “detonates.” We hope to sensibly organize our thoughts on the subject by structuring the conversation in the following general order:
- First, we’ll begin by explaining what risk does and does not mean to us, and why we define risk differently than do many others in the investment world.
- After defining the type of risk that we seek to mitigate, we’ll move on to our first principle of risk mitigation: trying to reduce price risk by buying as cheaply as possible. Of course, “cheapness” is in the eye of the beholder, so we’ll discuss how and why our valuation methodology differs from other approaches commonly applied today, and why we believe our approach to valuation contributes to reducing price risk. We’ll conclude this section with an example of why cheapness and “buying right” matter.
- While buying as cheaply as possible is necessary in order to mitigate price risk, unfortunately it’s not enough, by itself, to create what we consider a “margin of safety.” It’s a great start, but a host of additional risk factors, both internal to each individual business and external, must also be carefully considered.
- Even if each individual business or asset in an investor’s portfolio has a risk profile that he or she considers to be manageable, other risks, which instead reside at the level of the portfolio, can conspire to wreck long-term returns. With that in mind, at this point we’ll move on from risks facing each individual investment to those risks which affect the portfolio in aggregate.
- Finally, we’ll explain what we mean by “knowing the neighborhood you’re going to,” and why and how we believe that an ongoing awareness of one’s surroundings and healthy, informed skepticism help in mitigating the big, “unimaginable” risks that could strike.
The following discussion is admittedly a very lengthy read, but we believe that it’s long for good reason. Risk is a topic that is incredibly vital to the ultimate success or failure of any investment program, but it is also complex and multidimensional. In our view, effective risk management requires a thorough, holistic approach that looks for any and all potential risks to the portfolio from a variety of angles. We hope that you find it informative.
Risk: What It Is Doesn’t Mean to Us, and Why
Perhaps a sensible first step in discussing how we think about, recognize, and deal with risk in our portfolios is to ask ourselves the question, “What is risk?” in the first place. To us, this is not as simple as it might sound, as we view risk as a somewhat squishy, imprecise sort of idea which could mean a wide variety of things. Different investors define risk and think about how to deal with its presence in their portfolios in many different ways depending on, among other things, their specific investment philosophies, approaches, and constraints under which they operate. Simply put, in the investment world, “risk” means different things to different people. Before we dig into the details of what risk means to us, we’ll begin with what it does not mean at Moerus.
Principal measures of risk that you have probably come across if you’ve studied traditional academic finance, and indeed which are used by many players in the investment community, typically rely in some form or another on statistical measures of volatility. In plain English and without digressing into the mathematical minutiae behind any of these measures (unnecessary, fortunately, for the purposes of this discussion), many of these statistics are, generally speaking, derived from measurements of historical movements in stock prices, sometimes extremely short-term in nature. The theory – again, we are admittedly oversimplifying things grossly – is that if Stock A’s price history has consisted of a non-stop roller coaster ride of sharp ups and downs, while Stock B’s price history has seen relatively stable, modest moves along a reasonably smooth path, then Stock A is deemed more volatile and therefore “higher risk” than Stock B.
In such a case, the fact that Stock A has historically been more volatile than Stock B is an objective matter of record. And for those who associate risk with historical volatility in stock price, Stock A is, by their own definition, indeed riskier than Stock B. We are quite certain that for many investors, this is a very sensible and appropriate way to view and measure risk. But for us at Moerus, we do not think about risk in terms of short-term share price volatility – that simply would not make sense within our framework of long-term, deep value investing. Why not? Much of the answer is linked to our investment approach, which we detailed in our first Investor Memo, but perhaps it would be helpful to briefly revisit some of these points, as they relate to how we think about risk.
At Moerus, we try to buy assets and businesses cheaply, with the goal of achieving capital appreciation and attractive risk-adjusted returns over the long term. “Cheapness,” like “risk,” means different things to different people, and we will dwell a bit on what it means to us shortly, but the key point we are hoping to make here is that from our perspective, we are buying interests in businesses and assets. The stock prices associated with those businesses fluctuate in value every day, some days more sharply than others. There are times when short-term stock price movements up or down may reflect a genuine increase or reduction in the long-term, intrinsic value of the underlying business in question; perhaps, for example, the FDA declines to approve a prospective drug that was considered crucial to the future prospects of a small biotechnology company that’s essentially a “one trick pony.” But in many cases, we believe that day-to-day stock price movements do not reflect changes in the fundamental, intrinsic value of the underlying business as much as they instead reflect a host of other factors, perhaps most notably investor/trader psychology.
How else could we make sense of countless cases in which, for example, a company’s stock price declines in value by 20% in one day because its quarterly earnings per share (EPS) missed analysts’ estimates by a few cents? Could this company’s true value really be worth 20% less than it was yesterday? Maybe with the benefit of hindsight, market expectations had been irrationally optimistic, and therefore the stock was previously overpriced and such a decline is justified. On the other hand, maybe the 20% decline in the stock price was an overly harsh overreaction, and as a result the stock is now underpriced. Either way, in such a case either yesterday’s or today’s stock price misrepresent the long-term, enduring intrinsic value of the business – maybe they both do – but in any event, it is difficult for us in many cases to truly believe that the long run, intrinsic value of a business can change by so much overnight, because of something so immaterial to its long-term viability as its EPS over a three-month period falling a few cents short of analysts’ expectations.
Since day-to-day stock price movements do not, in our opinion, typically reflect commensurate changes in the fundamental value of our portfolio holdings, we believe it does not make sense for us to spend much time viewing short-term volatility as “risk” and trying to avoid or mitigate it. Share prices will do what they have always done, zigging and zagging as market sentiment swings back and forth from excessive pessimism to excessive optimism, over and over again, with many starts and stops in between. This is simply a reality of financial markets, and rather than focus on short-term share price volatility as a risk that we must mitigate, we often look to it as a source of compelling long-term investment opportunities that become available only fleetingly due to temporary turmoil and adversity. For us, short-term volatility is a friend more often than a foe.
Global Risk Appetite
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