How To Mitigate Against Risks When Value Investing

Fundamentals 03:  Risks differ depending on the type of assets and investment style.  This post looks at risk and risk mitigation from the perspective of a stock-picking value investor.  Revision date: 22 Aug 2020


Risk
"Risks come from not knowing what you are doing" Warren Buffett

When you invest in equities, the goal is of course to get a better return compared to keeping monies in fixed deposits. 

Unfortunately, the returns from equity investment are not guaranteed.  There will be times when you will make less than what you can from fixed deposits. 

Worst still there will be times when you lose all your investments. The challenge is how to mitigate against them.

There are 2 schools of thought when it comes to risks
  • Those that treat risk as some form of variance
  • Those that consider risk as permanent loss of capital

This post is about how to mitigate against permanent loss of capital. This is because I look at investments from a long-term perspective. Any variance is a paper loss or gains that I do not worry about.

BTW, this is not some textbook treatise. Rather it is based on what I have adopted over the years.  I hope it will be of some practical use as you invest.


Contents

  • What is risk?
  • 3 Buckets strategy
  • Risk management matrix
  • Risk mitigation measures
  • How to us the margin of safety
  • Risk and Valuation
  • Why rate companies?
  • Risk management and Portfolio construction
  • Pulling it all together


What is risk?

Some would consider risk as to the likelihood of not earning what you expect. However, I would argue that if you still have some money left, there is a chance that you can make back what you lost. 

However, this is not the case if you lose all your investment. I thus consider this as the real risk of investing in equities, what Warren Buffet refers to as a permanent loss of capital. 

Over the years, I have suffered such permanent loss of capital from 3 situations:
  • Selling during a temporary price drop thereby converting the temporary loss into a permanent loss. I think I no longer have this risk having learned to invest for the long term. At the same time, I do not invest using borrowings so that there is no pressure to sell an investment at the wrong time.
  • A deterioration in the intrinsic value to permanently below the purchase price. Over the past 15 years, I have had 3 cases of such losses. Two were due to outright fraud by the companies while the other was due to business risks.
  • Privatization by the controlling shareholders. There have been occasions where I have benefited from a privatization exercise. But there were a few privatization exercises where the offered price was below my purchase price. OK, you can argue that I should have bought the shares with more margin of safety.
What is the moral of the story here? Having a margin of safety is often seen as a way to protect against bad luck and valuation errors. However, no amount of margin of safety can protect you against fraud. 

Apart from the risk arising from valuation errors and outright fraud, you are also exposed to the company’s fundamental risks (business and financial) as well as the country’s macro-economic risks. 

Finally, there is also a risk in the type of investments you make.
  • It is definitely riskiest to invest in turnarounds.  These are companies facing some problem that needs to be addressed in order to return to profitability. There are lots of upsides if the company can achieve the turnaround as the market would probably have priced the company as if there is no hope
  • If you invest in a high-quality company, there is less risk of a permanent loss of capital. Of course, the gain may be less than what you would get from investing in a turnaround.


i4value: Managing Risk


3 Buckets

There is a link between asset allocation and risk mitigation in the sense that the more you allocate to risky assets, the greater is your risk.

So I have a 2-tiered asset allocation strategy
  • First to allocate the net worth based on the 3 Buckets strategy.  This will identify the amount of your net worth to be set aside for investments in risky assets
  • Next, allocate the amount set aside for risky assets from a risk mitigation perspective.

The 3 Buckets strategy is about dividing your net worth into 3 parts
  • Bucket 1 - have 2 years of your annual expenditure as cash.  This is meant for emergencies so that you do not have to sell the risky assets at the wrong time
  • Bucket 2 - have another 8 years of your annual expenditure in those assets that protect the principle.  These could be government bonds or properties.  The goal is not to make monies from these assets.  Rather it is to provide assurance that you have some savings.
  • Bucket 3 - the balance of your net worth is in this bucket.  This is for investing in risky assets whose prices can vary over time.  By having some of your net worth in Buckets 1 and 2, you can take a long -term view and ride our market variations.
  • Periodically re-balance so that you maintain the amount allocated to each Bucket


Risk management matrix

My approach in protecting against risk is to first identify all the things that can go wrong in the valuation process.

Then I adopt several measures to protect against the various risk items.

From a value investing perspective, I would categorize all the things that can go wrong into 3
  • Those that lead to a deterioration in the intrinsic values. These are generally due to changes in the business fundamentals.  These in turn are due to socio-economic, political, secular and business strategies changes.
  • Those due to analytical errors. These could be computation errors.  There are even misleading information in the financial statements due to creative accounting. I would also place outright fraud here.
  • Those due to behavioral biases. 

To minimize the impact of the above risks, I adopt the four standard risk mitigating strategies.  
  • Accept: With some risks, the expenses involved in mitigating the risk is more than the cost of tolerating the risk. In this situation, accept the risks and carefully watch them. 
  • Avoid: In general, avoid risks that involve a high probability impact for financial loss and damage.
  • Transfer: Mitigate risks by sharing or transferring them.
  • Reduce: The most common mitigation strategy is risk limitation

Following this approach, you then have a matrix with the 4 risk mitigation measures on one axis and the 3 risk categories on the other axis.

You then identify what can be done in each of the cells formed by the intersection of the items in each axis.

An example of my risk mitigation strategies using this framework is shown in the chart below



Risk Mitigation Matrix


Over the years, I have learned that risk is not some number.  There are many ways to suffer permanent loss of capital.

The best is to approach risk analysis and risk mitigation from several angles.  I slice and dice what could go wrong in many ways.

The risk mitigation framework above is only one perspective.

The sections below provide other perspectives


i4value:  Risk mitigation measures




Risk mitigation measures

Since risk can come from many sources, you will need to cover it from many angles as follows:

1)  Adopt a conservative approach in the valuation. Use conservative estimates for the various valuation parameters.      

For example, if there are growing trends for the profits and/or cash flows, any valuation that assumes zero growth will be conservative.


2) Have different levels of the margin of safety depending on the nature of the investment.  

For example, have a larger safety margin for companies going through a turnaround compared to one with a "consistent" track record. I also choose companies with some dividend track record as I consider dividend payment as some form of margin of safety. 


3) Focus on quality stocks and those with a long operating history to guard against fraud and the business environment. 

I have incorporated a number of academic quality and risk indicators in my analysis. Examples are the Beneish M Score, the Piostroski F Score, and Altzman Z Score. 

To help in this evaluation, I have also developed a Q Rating system. 


4) Diversify. I adopt a 2-tiered diversification plan. 
  • Firstly, I invest in several asset classes with equity as only one of them. 
  • Secondly, I hold a portfolio of about 30 to 40 companies.  These are from different sectors, market capitalization categories of investments.  (Refer to the valuation posting to see how I categorize my investments)


5) Understand the company. Get a good picture of how it got to its present position.  

Understanding its business model and strategies helps me get a handle on its fundamental and macro-economic risks. 


6) Invest in the long-term. This helps to mitigate any short-term economic upheavals.


7) Be prepared to cut loss if the investment thesis is no longer valid. 

I have done this several times.  While there are some initial losses, I can more than makeup for the losses by investing the money in other companies with better prospects.


8) Invest more in those where you have more confidence. This is related to the position sizing strategy. (Refer to the Portfolio construction section below) 


9) Incorporate Beta into the valuation. When I first started, I used one discount rate in my valuation.  To account for the risks, I now use the Capital Asset Pricing model to determine the discount rate. 

OK, this is a bit more technical and you can get more info from my Definitions page.


10) At the end of the day, the best risk mitigation strategy is to look at the investment from the downside protection perspective.  Let the upside take care of itself.  Don’t think of the returns that can be made.  Rather think of how to prevent losses.


I am sure that there are many other ways to protect yourself. If you have other ideas, I would be delighted if you could share them with me.

How to use the margin of safety

Warren Buffet considered "margin of safety" as the 3 most important words in investing. 

The concept of the margin of safety in investing was popularized by Benjamin Graham, the father of value investing. 

It refers to the extent to which the market price of a company is below the estimates of its intrinsic value.   It offers you some protection in case you made some error in estimating the intrinsic value. 

When I first started to invest, I was confused about the margin of safety. I look at it from the engineering perspective.  

I initially considered the margin of safety as some protection for the value in case I have made some computation error or had some wrong assumptions. 
  • If the computed value of a company is RM 10 per share, I would then conclude that the true value is probably RM 7 per share if the margin of safety is 30%.
  • Then if I want to buy at a 20 % discount to the intrinsic value, I would only buy if the price is RM 5.60 per share or lower. 

But as I read further, I found that my engineering perspective is too conservative.   Many investors and analysts using this concept would buy when the price is RM 7 per share if their margin of safety is 30%. It seems that the industry practice is to treat the margin of safety as a discount. 

Nowadays I don’t discount twice and follow the industry practice as I have already adopted a conservation valuation approach. Accordingly, the margin of safety is also an indication of the potential upside for the investment

But more importantly, you make many assumptions in valuing companies.  Just because it is mathematically correct does not mean that it reflects reality.  The margin of safety is recognizing this imperfection. 

Risk and Valuation

To bring risk to the valuation analysis, I adapt Professor Bruce Greenwald's approach of comparing Asset value (AV) and Earnings value (EV). 

I look at the margin of safety in the context of the AV and EV analysis with the following 4 scenarios:

Excellent margin of safety
Scenario 1: Excellent margin of safety. In this case, the market price is significantly below both the AV and EV
Acceptable margin of safety
Scenario 2: Acceptable margin of safety. In this case, the market price higher than the EV but lower than the AV. If you invest in a company under this scenario, it must be because you believe that the company would be able to turnaround and that in the worst-case scenario, the value of the assets would offer some protection if the business fails.
Better than acceptable margin of safety
Scenario 3: Better than an acceptable margin of safety. In this case, the market price is higher than the AV but lower than the EV. In this scenario, you believe that the company’s competitive edge would provide you with some margin of safety.
Poor margin of safety
Scenario 4
: Poor margin of safety: In this case, the market price exceeds both the AV and EV. The only rationale for investing in such a company is that you believe that the EV will increase over time i.e. you believe that this is some growth company whose future value has yet to be captured in the current EV. 

Why rate companies?

Benjamin Graham, the father of value investing has 10 criteria in his stock selection process. 

Half of the criteria relate to stock valuation while the balance covers the fundamentals of the company. 

The basic message is that any company you invest in must meet both your valuation target as well as the business performance target.

You assess the business performance both qualitatively as well as quantitatively. But when it comes to the quantitative evaluation many use some rating system. 

I found that many US investment advisors develop their own rating system to quantify the "quality" and or risk of a company. 

So given my engineering background, I reverse-engineered what I could find.  This enabled me to come up with a quantitative evaluation method.

In investing, I would consider "quality" from the perspective of creating shareholders' value.
  • A high-quality company is one with a good chance of increasing its shareholders' value
  • A poor-quality company is one that may even destroy shareholders' value

Imagine a rating system that is pegged to all the metrics driving shareholders' value.  This is the basis of my Q Rating


Q Rating

The result is a rating system (referred to a Q Rating) based on 34 metrics covering 5 main parameters
  • Profitability
  • Growth
  • Financial
  • Other risks
  • Business model

It is a simple 1 or 0 scoring scheme for each metric.   
  • The scores for each of the main parameters are the average score of all the metrics associated with the parameter. 
  • I then compute the overall Q Rating by computing the simple average scores of the 5 parameters. 

Most of the information for the metrics are extracted from the company’s financial statements.   

As the financial statements for financial institutions are different, the Q Rating is not applicable to them. 

A number of the academic and research concepts such as the Beneish M score, Piotroski F score, Altzman Z score, Intensity of Core Earnings are part of the 34 metrics. 

I have back-tested the Q Rating against many performance indicators such as total return, ROE, and growth.   I found that a high Q Rating score points to a likelihood of positive total return in the coming 4 years. 

I analyze about 80 – 100 companies every year and I update the Q Rating accordingly. 
  • I have found that the Q Rating for a specific company varies with the economic climate. 
  • The Q Rating is a relative rating scheme ie how does a particular company score relative to the rating of all the companies covered.  

The table below the range of the Q Rating for two sample periods

Interquartile position

Q Rating

Financial year 2014/15

Financial year 2017/2018

33 % position

0.47

0.41

50 % position

0.56

0.50

67 % position

0.62

0.56

Average

0.55

0.49


To help such an assessment, I determine the Q Rating quartile score for the year and then compare individual company Q Rating against this quartile score. 

There are several ways to interpret the Q Rating:
  • Use it as a “quality” or performance indicator that is independent of the price or value of a company. A relatively high score meant a higher “quality” company.
  • I often use the Q Rating as a proxy for risk where are low Q Rating means a riskier company.
  • Use it as a ranking scheme to categorize companies into types of investments. Investing in a company with a high score is equivalent to investing in a high “quality” company whereas investing in a company with a low score meant investing in a turnaround case.
The key point is to see the Q Rating as another assessment tool. 

To help visualize the results, I generally chart the results as shown below

Sample Q Rating


Risk management and Portfolio construction

The main goal of having a portfolio of stocks is risk mitigation. You want a diversified portfolio so that if anything bad happens to one company, you are still OK on an overall basis.

But for this to serve its purpose, academic research shows that you need at least 20 different stocks to be well-diversified. These 20 stocks should be from different sectors.  I generally slice and dice them so that they are also from different market cap and investment styles (eg turnaround vs Graham Net Nets).

The real challenge is how to determine the amount to be invested in each stock ie the position size.  

There is a relationship between the number of stocks in the portfolio, the position size, and the total amount allocated to the portfolio. 
  • Imagine that you have RM 100,000 set aside for the portfolio. 
  • If you decide to have an equal amount invested in each of the 20 stocks, then you would invest RM 5,000 in each stock so that they sum up to RM 100,000. 
  • But you can also decide to have 20 stocks with a total investment of RM 100,000 but with different position sizes.

So how do you determine the position size?

I adopt a risk management approach to position sizing
  • I divide my portfolio into 3 groups based on conviction. 
  • The ones with the best conviction are those with the largest margin of safety, compounders and dividend-paying history
  • The ones with the least conviction are those facing turnarounds. These are deep value investments with a poor dividend track record
  • To simplify things, I have about an equal number of stocks in each category

How do I allocate my funds?
  • The ones with the least conviction are allocated RM X each. 
  • Then I would allocate RM 2X to each of those with the best conviction
  • The ones in between will receive RM 1.5X each
  • You can determine X mathematically so that the total amount invested comes up to the amount set aside for stocks. 

You can develop your own formula, but the key point is that it should have some risk mitigation basis. Otherwise, it defeats the goal of having a portfolio. 
     

Pulling it all together 

Risk is not a number.  For a long-term value investor, it is definitely not some variance. 

It is about a permanent loss of capital.  Risk mitigation is about doing all the things to prevent or minimize such a permanent loss.
  • It starts with how you allocate your net worth using the 3 buckets strategy
  • Then you allocate what has been set aside for risky assets into several asset classes. For example, I invest in properties and stocks.
  • For stocks, I invest as a value investor using a host of concepts to protect against risks
    • Adopt the risk mitigation matrix 
    • Follow a list of mitigation measures
    • Incorporate risk into valuation based on Bruce Greenwald approach
    • Rate companies using the Q Rating
    • Construct your portfolio with risk mitigation in mind

It is actually a frame of mind and what I have presented above are various tools in your toolkit to help you address them. 

Depending on your background you may lean towards the more quantitative approaches or to the more qualitative ones. The key point is that you should use both. 



 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - 

How to be an Authoritative Source, Share This Post

Disclaimer
I am not an investment adviser, security analyst or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned in this website may not be suitable to you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

Comments

Popular posts from this blog

Is Eksons a value trap? (Part 1 of 2)

An Introduction to Value Investing - confronting value traps