Baby steps in assessing Permanent Loss of Capital

Case Notes 04: This is a post about how I compared the risk of investing in two companies from a permanent loss of capital perspective using a risk management framework.

In investing, there are 2 schools of thoughts about risk

• The volatility school that view risk as variance

• The permanent loss of capital school that view risk as a permanent reduction of the amount invested

The volatility school has strong academic credentials.  This branch of finance theory has developed to a stage where you can numerically bring risk into the valuation process.  

But all the discussions on risk as permanent loss of capital are qualitative.

If you are a beginner in investing following the permanent loss of capital school, how can you manage risk? Specifically

• How to compare risks between two companies?

• How to methodically bring the permanent loss of capital into the investment process?

This can be achieved through a risk management approach comprising:

• Identifying the possible causes that can lead to a permanent loss of capital

• Assessing the threats 

• Mitigating permanent loss of capital using risk management strategies. It involves avoiding, accepting, reducing, or transferring them. 

This risk management framework enables you to compare the permanent loss of capital for different stocks.   It also integrates the permanent loss of capital into the investment process.

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Contents

• Permanent Loss of Capital

• Risk Management

• Possible causes for permanent loss of capital

• Assessing the threats

• Case study

• Risk mitigation

• Pulling it together

Permanent loss of capital

There is no question that all the proponents of the permanent loss of capital agree that it represents the risk in investing.

· “... permanent loss of capital is the risk that you might lose some or all of your original investment if the price falls and you sell for less than you paid to buy.” Weitz Investments Management

· “True investment risk is a permanent impairment of capital. In other words, an asset depreciates and never recovers.” Forbes

· “A better way to think of risk is as the possibility or probability of an asset experiencing a permanent loss of value or below-expectation performance.” Investopedia

Yet, I have not come across studies that attempt to quantify the potential “permanent loss of capital” in an investment. 

Rather most proponents generally focus on why volatility is not risk. They then proceed to describe the ways in which permanent loss of capital can occur.

This is unlike the volatility school which separate risks into systematic and non-systematic ones

• You manage non-systematic risk through diversification

• You aim for higher returns for taking on greater systematic risk

• You can also bring risk to your valuation by incorporating Beta into the cost of capital formula.

But the permanent loss of capital school approaches risks in a qualitative manner.  It then focuses on mitigating this permanent loss of capital. 

Nothing illustrates this way of thinking better than the risk portion in the book “The Art of Value Investing”. 

This is a book by John Heins and Whitney Tilson.   It collects the thoughts of experts on various valuing investing topics, including risk. 

Not surprising, there is no attempt to quantify or assess this permanent loss of capital. Instead, the experts offer insights on the measures taken to mitigate a permanent loss of capital. 

The following quote from the book exemplifies the position.

“Guarding against risk is built into every aspect of the best value investors' strategies, from the ideas they pursue, their buy and sell disciplines, how they build positions, how they structure their portfolios, how they manage cash, and how they hedge.”

Unfortunately, if you are learning to invest this is not going to help you assess and mitigate risks.

This article is an attempt to fill this void.

Risk management

“Risk management is the identification, evaluation, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability or impact of unfortunate events or to maximize the realization of opportunities.” Wikipedia 

There is a long association between risk management and insurance.  But in the 1950s other forms of alternatives to insurance started to appear.  This was when the cost of insurance was considered high relative to the benefits.

The discipline evolved and it became a more widespread concept with the growth of corporate governance. 

Today there is even an ISO 31000 standard for risk management. This provided the principles and guidelines for effective risk management.

The risk management process involves the following

• Identify the causes that can lead to the risk

• Assess the risk in the context of the impact and the likelihood of the occurrence

• Formulate the mitigation measure to manage the risk

The strategies to manage them cover

• Avoidance - what can be done to prevent it from happening

• Reduction - how to minimize the impact of any risks

• Transfer - is there a way to transfer the risk and/or the consequences to another party

• Accept - in some instances where the cost of mitigation outweighs the benefit of the mitigation strategies, it may be better to live with the risk

If you consider the permanent loss of capital as risk, there is no reason why we cannot use the risk management framework to manage risk. 

Specifically, the article will

• Identify all the causes that can lead to a permanent loss of capital

• Assess each threat

• Formulate the mitigation measures based on the 4 risk management strategies

Possible causes for permanent loss of capital

To suffer a permanent loss of capital, the investment has to be sold at a price that is lower than the buying price.  

For simplicity, I will ignore the situation where the investment has been sold due to short-term volatility.  From a value investment perspective, this is unlikely to happen. 

Rather I assumed that any sale is because the price is “permanently” below the purchased price due to the following direct reasons

• Deterioration in the intrinsic value due to changes in the fundamentals - both macro and micro

• Issues with portfolio construction

• Wrong assessment of intrinsic value in the first place

• Stock market changes due to regulatory changes

These are the main direct causes and there are other root causes for each of them. 

To help identify the root causes, I have used the Ishikawa fishbone diagram to help identify the various cause-and-effect.  

Ishikawa diagram

The details of each of the root causes for the boxed items in the Ishikawa diagram are presented below

Stock Market Changes

• Privatization - you are sometimes forced to sell at below your purchased price due to a privatization exercise

• Regulatory - these relate to rules that affect the availability of the stock eg trading restrictions. There is a “feedback loop” here.  If the business deteriorates there is a higher likelihood of some listing guidelines that may affect its liquidity.

Wrong initial intrinsic value

The assessment of intrinsic value is the heart of value investing. If this was wrongly assessed at the start, the purchase would be a mistake that would be realized much later.

• Governance. The intrinsic value is generally assessed based on the financial statements. If there are issues due to the poor quality of earning or even creative accounting, the computed intrinsic value would be wrong. 

• You could have made some analytical errors in assessing the intrinsic value. You are more likely to make errors if the company has a more complex business model

• Your behavioural biases can skew your estimates of intrinsic value. Again, there is a high likelihood of more behavioural biases in analyzing and valuing a company with a complex business model. 

Portfolio construction

• Position size. This relates to the number of stocks in the portfolio and the amount to be allocated to each stock. 

• Cash management. From an individual investor perspective, the amount of cash you hold affects your holding power.  You should have enough to handle emergencies without being forced to sell your shares at the wrong time. The amount of cash also affects the ability to take advantage of the market but I don’t see this as critical in the context of a permanent loss of capital.

• Hedging refers to other strategies of guarding against risk eg taking a short position

Deterioration of intrinsic value

The intrinsic value of a company could decline over time. Over the long term, the market price will decline to reflect this.

• Management could be the cause of the decline.  This could be adopting the wrong strategy or plain incompetence

• Financials - if the company has debt, there could be changes to the loan situation eg higher interest rates that affect its profitability or cash flow

• External - this covers all the social, political, and economic changes that negatively impact the company.  I would include technological changes here as well. 

The above Ishikawa diagram shows the first level cause-and-effect. You can have a second or even third-level cause-and-effect diagram for the more complex cases.  

For example, in the case of the External factors, you could further break it down into

• Different economic factors eg interest rate, GDP growth, inflation

• Different social factors eg demographic trends, migration patterns

Assessing the threats

The goal of threat assessment is to evaluate the likelihood of occurrence of each of the threats and the impact. 

I classify each cause in the Ishikawa diagram into one of the following 4 coloured cells based on the assessment of its impact and the likelihood of it occurring as per the table below

Threat Matrix

The above is a visual and qualitative approach.  

In theory, it is possible to assign a score to each cell so that we can have a quantitative assessment.

However, there are two challenges to such a quantitative assessment

• How do you validate the score assigned to each of the cells?

• How do you weigh the individual threat items to derive an overall score? 

The question is whether such a scoring method would provide any useful information compared to a visual assessment.

Case study - Comparative visual assessment

To be able to assess the threats there is a need to first analyze the companies.  Such analyses have been carried out for 2 companies - Eksons and Asia File - whose details can be viewed on other posts in this blog. 

For each company, I categorized each of the causes of permanent loss of capital (as per the Ishikawa diagram) into the relevant threat category (as per the Threat matrix). 

The comparative results and rationale are tabulated below.

Based on a visual comparison, you would conclude that an investment in Asia File would have less risk compared to a similar investment in Eksons.

The above is mainly a first level cause-and-effect assessment (although I did go down to the second level in the case of the External factors)

You can go down into a second or even third-level cause-and-effect assessment if need to.  

Comparing the risk between Eksons and Asia File through a permanent loss of capital lens

Notes

a) Any regulatory issues affect both companies equally

b) Because of the shareholders' profile and cash available in the company, I consider a greater likelihood of Eksons being privatized. Of course, whether you suffer a permanent loss of capital would depend on your purchased price.

c) Since both stocks are in the same portfolio, they share the same risk profile, and hence I have not attempted a finer breakdown

d) I use the same analytical process for both so they share the same assessment. My margin of safety minimizes the impact of any error here

e) I relied on the Q Rating (refer to Note 1) to assess Eksons to be riskier. My margin of safety minimizes the impact of any error

f) Eksons has a simpler business model and hence less analytical and valuation issues

g) Both companies are financially strong

h) Asia File is more likely to face digital disruption 

i) Eksons is facing log supply issues resulting from the government logging policies

j) Asia File management has a stronger track record

What to do with the results

Although this is a simple visual assessment, I have used the results in the following manner

• Position sizing.  The concept behind the Kelly Formula is to invest more in those with the greatest payoff and the best probability of success.  I translate this to mean that I invest more in Asia File compared to Eksons.  I believe that this is in line with the idea that you invest more in those with a higher conviction

• The margin of safety.  This margin is to protect you against bad luck and other errors made in the investment process.  I would require a smaller margin of safety for Asia File compared to Eksons

Pros and Cons of the methodology

The goal of the assessment is to have a standard way of comparing the risk between several companies.  

A visual assessment serves this purpose

Unfortunately, it is not very meaningful if you want to assess the risk of just one company. 

I see the following as the Pros and Cons of this approach 

Pros

• Simple visual assessment

• A consistent basis to compare

• Relates to the reasons for permanent loss of capital ie risk

Cons

• Requires detailed analysis of each company

• May not be practical if comparing many companies together 

• Different parties may come to a different assessment

• Dependent on identifying the correct cause-and-effect

Risk mitigation 

Given the various items that can lead to a permanent loss of capital, the risk management approach is to identify various measures to handle them.

The table below summarizes the various measures that I have adopted categorized into

• Avoiding the threats

• Reducing the likelihood or impact of the threats

• Accepting the threat 

You will notice that some measures cut across several risk mitigation categories

At the same time, to transfer some of the risks, I have some of my net worth invested in unit trusts and properties. These have a different risk profile than those of stocks. 

Furthermore, if you view the threat as a function of both the likelihood of the event and the impact of the event, then depending on the nature of the threat, 

• Some of the measures focus on the likelihood 

• Some focus on the impact 

• Some cover both likelihood and impact

Risk Mitigation Strategies

Most of the measures adopted a self-explanatory. But for some others, I provide a brief description (in alphabetical order) as follows:

• Analyze shareholders - privatization will also depend on whether the controlling shareholder sees any advantages in maintaining the listing status. 

• Avoid deep value - deep value stocks are those that are generally trading at a deep discount to the Asset values.  These are potential privatizations

• Cap investment - this is to ensure that there is no concentration in a particular stock

• Cost-benefit - only hedge if the benefits outweigh the cost

• Cut loss - be prepared to sell and cut loss if you have made an error in your analysis and/or valuation

• Don’t rush - this refers to slowly building up or exiting a position. It is likely that you may look at a stock differently when you are invested

• More for high conviction - this relates to investing a bigger amount for those stocks with higher conviction.  

• Quality of earnings - this relates to the proportion of income attributable to the core operating activities of a business.  You ignore any anomalies, accounting tricks, or one-time events.

• Several sectors - diversification is not only about investing in several companies.  It is also to ensure that the stocks in the portfolio are from different sectors. The goal is to ensure that there is no concentration in any particular sector

• SOP - have standard operating procedures 

• Understand management - evaluate management from several perspectives ie as an operator and as a capital allocator. 

• Use various metrics - there are many metrics and techniques when it comes to valuation.  Adopt a number of them so as to triangulate the intrinsic value

• 3 Bucket - this refers to an asset allocation strategy where the net worth is spread into 3 asset classes ie liquid, safe, and risky assets. 

Pulling it together

• With the permanent loss of capital as risk, you can adopt the risk management process to assess risk and bring it into your investment process

• Risk management involves identifying the threats, assessing, and then mitigating them.  You consider both the likelihood of the event happening and its impact.

• The mitigation measures involved avoiding, reducing, accepting, and transferring the risk

• There are various ways you can suffer a permanent loss of capital. They can be due to stock market changes, portfolio construction, wrong estimation of intrinsic value, and deterioration of the intrinsic value. 

• A risk management framework was used to assess the likelihood and impact of each of the threats. This was then used to compare the relative risk of different stocks

• The risk management framework was also used to identify the various measures to adopt to mitigate a permanent loss of capital

When you invest, you not only have to analyze and value companies, you also have to think about risk. I have presented one framework for risk assessment. Other investment advisers have their own methodologies.  The important thing is that if you are relying on others to analyze and value companies, you have to ensure that they also cover risk assessment. Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can have the business analysis, valuation, and risk assessment.

Note

1) I would consider quality as being related to the creation of shareholders’ value.  A high-quality company would then be one with a good likelihood of increasing shareholders’ value.  A low-quality company is one that is likely to destroy shareholders’ value. The Q Rating assesses this dimension of quality. About 80 companies across a number of non-financial sectors are covered annually.  For further details, refer to the posting  "Q Rating"

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