Image Source: Mike Cohen
By Matt Warren
Let’s start by talking about what isn’t risk. Risk isn’t easily measured and yet that is what the asset management industry and academia tend to serve up to the average and professional investor alike. You will see the standard deviation of a stock or portfolio, showing how much the value wiggles. You will see beta, which shows how much the value wiggles as compared to the benchmark’s own wiggles. You will see things like the Sharpe and Sortino ratios, which tackle further quantifiable ways to describe risk–and the list of equations goes on and on.
Do you know what is a much more difficult question for an asset manager to answer? How much real risk is contained in your portfolio? I was going to say fundamental risk, but real risk is a broader category and what I am driving at in this piece. So, let’s get after it: What is real risk as it pertains to an individual investment or a portfolio?
Overconfidence: The biggest risk is that the investor doesn’t know what they are doing. If you have spent any amount of time in the investment industry, I am sure you have met someone who is simply in over their head. Symptoms include magical thinking (“stocks only go up”), lack of relevant education or experience (perhaps they have never looked inside a DCF model before), completely lacking street smarts (understanding greed and fear), etc. Smartly, the asset consulting industry does seem to do their best to ascertain this risk by interviewing as many of the investment team as possible. Character matters too. Of course, there are limits to what can be achieved in this due diligence, but better to have tried and failed then to have never gone down this road.
Overpaying for Truncated Earnings: Real risk is paying a full valuation for earnings that are ephemeral in nature. Headwaters, a maker of building products, comes to mind. The firm, which was later acquired by Boral, was making a bunch of money turning coal into fuel on the basis of a subsidy that was scheduled to sunset. Analysts were arguing the subsidy would be continued, or that Headwaters would magically replace these earnings with earnings from another source. It never happened and the stock tanked as the sunset approached. It’s risky to pay a full multiple for earnings that may not continue into perpetuity. Another example of this is Gilead (GILD), which in curing hepatitis C, truncated its long-term earnings potential with the drug. Near-term earnings weren’t reflective of long-term potential. Even the department stores such as Kohl’s (KSS) may fit this bill, as long-term earnings may be eroded by structural e-commerce proliferation. The enterprise discounted cash flow process helps investors think through whether earnings are sustainable.
Groupthink: Real risk is groupthink. Read about the hazards of groupthink in: “Don’t Follow Social Media Likes: The Divine “Comment(y).” The piece walks through how many failed to challenge their underlying assumptions when assessing the valuations of master limited partnerships (MLPs) on a price-to-distributable cash flow (P/DCF) or distribution yield basis. Using the DCF is a great way to assess whether multiples make sense as the process acts as an absolute anchor to intrinsic value, where relative valuation parameters can drift away from reasonable fundamental expectations.
Overpaying for Potential: Real risk is buying into a hype cycle. Peloton (PTON) comes to mind as a current example. The product is fantastic. Wealthy people and cycling fanatics are buying up the products like hotcakes. Rapid revenue growth and signs of potential margin expansion are evident. The problem is the valuation, which is many multiples of sales. In fact, investors should understand that most multiples could be misleading. An investor buying into a hype cycle thinks the runway is very long. They think the substantial and mounting competition will not take meaningful share, as returns are inevitably pressured. They think it is okay to charge $50/month subscription to loyal buyers of hardware (bikes and treadmills), while only charging $15 to those riding a cheaper bike bought away from Peloton. Hype cycles on high multiples of earnings, let alone sales, almost always end badly. Tesla (TSLA) might be another one that meets this criteria. The only question is whether the investor is wrong that a story is, in fact, a hype cycle?
Not Considering Liquidity Risk: Real risk is not understanding which companies with varying degrees of leverage can withstand recessions of various magnitudes and durations. For a long-term idea to work out, it must make it through the near term. Investors that paint a bright long-term picture must first make sure the company will survive the near term with the existing equity capital intact; otherwise, shareholders could get wiped out.
Not Learning from History: Real risk is completely discounting the possibility of another great depression happening. This risk is so pervasive that it is the absolute norm. If there is another depression in our lifetimes, many if not most will be wiped out, only to restart the generational cycle.
Avoiding Varying Perspectives: Real risk is having a policy of not checking in with the sell-side (we do all our own work!) to see what details they caught with their substantial resources and to assess the generally accepted narrative at a point in time. What would cause them to change their rating and price target?
Not Considering Leverage: Real risk is an overleveraged company, no matter how high quality. For starters, many an investor may ignore the balance sheet and only focus on a multiple of earnings, but the multiple of earnings is impacted by how much net debt is on the books. All else equal, a company with a large net debt position will trade at a lower multiple than a company with a large net cash position. In some ways, the whole leveraged private equity industry is a high-risk scheme. Can it work out on average through the cycle? Sure. Just don’t be the sucker that buys into the wrong vintage before a severe magnitude and duration recession. That’s when the real risk materializes in an ugly way. Companies go bankrupt, employees are laid off, and in some cases Geoffrey the Giraffe is left scrambling to find a new home. Business Development Companies (BDCs) are predicated on clients taking on too much leverage to get paid out today for tomorrow’s earnings. Buyer beware.
Overestimating the Long Term: Predicting the long term is difficult. Real risk is mischaracterizing or ascribing a missing economic moat, or outsize returns over the long haul. If the analyst imagines a moat that in fact is not there, they can write all kinds of beautiful prose about the moat source and make compelling arguments on powerpoint to the client, but if there is not one there, then it is all for naught. The investor overpays for the asset or waits forever for a premium to show up, leaving other investible opportunities in their wake. Mischaracterizing the nature or strength of the long term is similarly damaging to the eventual outcome.
Not Properly Diversifying: Real risk is unwittingly cramming a portfolio full of correlated risks. The housing bubble comes to mind. An investor pursuing outsized growth and returns above the cost of capital could easily have added mortgage banks, Black & Decker (SWK), aggregate companies, mortgage insurance companies, bond rating firms, and investment banks into their portfolio. In fact, some investors did things just like this and got their heads handed to them between the time of the first hedge funds blowing up in middle 2007 and Lehman Brothers failing a year a bit later. This risk can ruin portfolios and end careers.
Fear of Missing Out (FOMO): Real risk is one-way market fueled by nothing more than career risk. It can be a melt up that is bought or a melt down that is sold. The point is that the investor finds themselves on the wrong side of a momentous move and starts chasing late in the trade. Models are ignored and money is lost.
Over Relying on One Metric: Real risk is putting too much weight on any one valuation metric. P/E ratios are ambiguous. P/S ratios are dangerous and have been credited with causing the dot-com bubble. EBITDA is simply not a good measure of earnings, as in EV/EBITDA; Charlie Munger calls EBITDA ‘bulls**t earnings.” Even DCF models can break. We’ve seen it published on C-1 in the Wall Street Journal. Aside from colossal embarrassment, shouldn’t the analyst have caught his error by triangulation with other valuation metrics, even if less efficacious in general? As Value Trap explains, any multiple can be expanded into a DCF, so multiples and the DCF are implicitly tied together. Valuation does not exist in separate vacuums. The DCF is universal.
Failing to Seek Disconfirming Evidence: Real risk is a portfolio manager that wants people to say what they want to hear. Investors should challenge their thesis as new information comes to light by seeking disconfirming evidence. Being open to changing one’s mind is one of the most valuable attributes of any analyst or portfolio manager.
Not Doing Enough Due Diligence: Real risk is not making all efforts to talk to the company and its key individuals. The same as the consultant should be checking out the investment firm, the investment firm should be checking out the folks running the company. Management and company culture can drive the best and the worst outcomes. It’s even good to know if the company is simply in the big middle; at least they won’t flush their competitive advantages down the toilet.
Overestimating Your Circle of Competence: Real risk is a stock analyst pretending to be a legal expert, when they don’t have the skill set. At best, they can consult lawyers, but better not to put 10% of the portfolio into a name under a legal cloud that might not be well understood.
Not Assessing Context: Real risk is not taking a 360-degree view of a firm and its place in an industry. Followers of Zen know this. It applies to investing too. Walk around to the other side and take a look from over there. Consult expert networks. Get on the horn and do channel checks if possible.
Others:
Real risk is putting too much weight on any one source.
Real risk is getting so wed to a thesis that you start discounting new contrary information.
Real risk is not reading the 10K.
Real risk is putting a lot of beta into a portfolio and thinking that you are smart when the market goes up 80-90% of the time anyway.
Real risk is alternating between bullish and very bullish. (Refer back to the Great Financial Crisis.)
Above, we touched on just a handful of the real risks involved in investing. This is by no means an exhaustive list. In fact, investing is just the type of enterprise that will introduce you to new mistakes every year of your career. Just try to learn from them and carry on. So–the next time an investment firm shows you how to measure the wiggles of the realized performance, please ask them what real risks are in their portfolio. If they are straightforward, I’m sure you will easily be able to add to my list here.
Related BDCs: ARCC, AINV, GAIN, NEWT, PNNT, TCPC, GSBD
Related ETFs: BDCL, BDCS, BIZD, FGB, LBDC