James Montier of GMO is a commentator that intelligent investors should listen to. In his most recent white paper (entitled “A Value Investor’s Perspective on Tail Risk Protection: An Ode to the Joy of Cash”), James talks about the increased enthusiasm for tail-risk protection that has appeared among investors and fund management companies. Much like many investment bank products, these “solutions” are sure to generate large fees, and feed the desire for more greed, rather than fear.
The article offers an in-depth (and technical) discussion on tail risk protection; however, I’m going to discuss the final section of the paper, which focuses on risk. For value investors, the risk-adverse approach to any investment is centered upon avoiding a permanent loss of capital. There are three forms of risk that can lead investors astray:
1. Valuation risk — this is the risk that is incurred when one overpays for an asset. Naturally, value investors have an unwavering focus on valuation and receive a sufficient margin of safety based on the price they pay. As a corollary, value investors naturally sell investments as the market rises due to the tightening on the gap between price and intrinsic value. In relation to tail-risk protection, value investors have a naturally tendency to load up on cash as the market hits higher levels, a form of tail-risk protection in itself.
As noted, the current actions by the Fed have led to the mindset that with cash returns close to zero, investors have no other choice but to stick with risky (overvalued) assets. Mr. Montier disagrees with this premise: “In our view it is better to hold cash and deal with the limited real erosion of capital caused by inflation, rather than hold overvalued assets and run the risk of the permanent impairment of capital,” he said.
2. Fundamental risk — this is the risk that comes from a reduction in intrinsic value, commonly in the form of a “value trap”. This is the current concern among large cap tech stocks like Microsoft (MSFT, Financial) and Cisco (CSCO, Financial), and the reason why such securities sell for single-digit earnings multiples.
A focus on fundamental risk is inherently focused on tail risk; for example, in the current environment, an analysis of fundamental risk for an asset must include a discussion of the impending effect of either deflation or inflation (both of which are a very real possibility).
With this discussion, cash (once again) appears to be a rational selection for portfolio allocation. Obviously, when we view the returns after the fact, cash is not the optimal choice during inflation or deflation; however, when looking from the present, cash is a robust asset that outpaces bonds during inflation (assuming cash rates are raised) and gains in real terms during deflation (unlike equities, as seen in Japan during the past twenty years).
3. Financial risk — this is the risk from over leverage and endogenous factors such as illiquidity and overcrowded trades. Over leverage is a poison that is best avoided (“smart people don’t need [leverage], stupid people shouldn’t use it”), while overcrowded trades are easily avoided by a contrarian view on the markets. Considering an inherent focus on valuation risk, value investors minimize the first risk; as such, they can focus more intently on the other two.
As tail risk becomes a focus of Wall Street, it begins to bear the seeds of a far too similar idea from the late 80s: portfolio insurance. As the price is driven higher, the benefits to buyers begin to diminish; like any investment, it must be bought with a focus on price and its relation to value.
Like usual, the worst time to buy is when the investment/asset is the “talk of the town,” a cycle that has happened all too many times before. As always, the approach to financial success is unchanged: Focus on a long-term value-based approach which keeps these risks in mind. While we can’t predict, we can prepare; make sure to analyze any and all fundamental risks within your portfolio, and hold some form of insurance (an example being cash) to prepare for the unknown.
To see the white paper, go here
The article offers an in-depth (and technical) discussion on tail risk protection; however, I’m going to discuss the final section of the paper, which focuses on risk. For value investors, the risk-adverse approach to any investment is centered upon avoiding a permanent loss of capital. There are three forms of risk that can lead investors astray:
1. Valuation risk — this is the risk that is incurred when one overpays for an asset. Naturally, value investors have an unwavering focus on valuation and receive a sufficient margin of safety based on the price they pay. As a corollary, value investors naturally sell investments as the market rises due to the tightening on the gap between price and intrinsic value. In relation to tail-risk protection, value investors have a naturally tendency to load up on cash as the market hits higher levels, a form of tail-risk protection in itself.
As noted, the current actions by the Fed have led to the mindset that with cash returns close to zero, investors have no other choice but to stick with risky (overvalued) assets. Mr. Montier disagrees with this premise: “In our view it is better to hold cash and deal with the limited real erosion of capital caused by inflation, rather than hold overvalued assets and run the risk of the permanent impairment of capital,” he said.
2. Fundamental risk — this is the risk that comes from a reduction in intrinsic value, commonly in the form of a “value trap”. This is the current concern among large cap tech stocks like Microsoft (MSFT, Financial) and Cisco (CSCO, Financial), and the reason why such securities sell for single-digit earnings multiples.
A focus on fundamental risk is inherently focused on tail risk; for example, in the current environment, an analysis of fundamental risk for an asset must include a discussion of the impending effect of either deflation or inflation (both of which are a very real possibility).
With this discussion, cash (once again) appears to be a rational selection for portfolio allocation. Obviously, when we view the returns after the fact, cash is not the optimal choice during inflation or deflation; however, when looking from the present, cash is a robust asset that outpaces bonds during inflation (assuming cash rates are raised) and gains in real terms during deflation (unlike equities, as seen in Japan during the past twenty years).
3. Financial risk — this is the risk from over leverage and endogenous factors such as illiquidity and overcrowded trades. Over leverage is a poison that is best avoided (“smart people don’t need [leverage], stupid people shouldn’t use it”), while overcrowded trades are easily avoided by a contrarian view on the markets. Considering an inherent focus on valuation risk, value investors minimize the first risk; as such, they can focus more intently on the other two.
As tail risk becomes a focus of Wall Street, it begins to bear the seeds of a far too similar idea from the late 80s: portfolio insurance. As the price is driven higher, the benefits to buyers begin to diminish; like any investment, it must be bought with a focus on price and its relation to value.
Like usual, the worst time to buy is when the investment/asset is the “talk of the town,” a cycle that has happened all too many times before. As always, the approach to financial success is unchanged: Focus on a long-term value-based approach which keeps these risks in mind. While we can’t predict, we can prepare; make sure to analyze any and all fundamental risks within your portfolio, and hold some form of insurance (an example being cash) to prepare for the unknown.
To see the white paper, go here
