Cobas Asset Management: Only the Ones Who Properly Manage the Risk Live to Tell the Tale

By Andres Allende: Rushing headlong, bluffing and going for broke do not work in the market. Only meticulous work, character (stamina and humility) and patience do

Author's Avatar
Sep 28, 2018
Article's Main Image

This past August I taught my children how to play the card game Mus. I particularly enjoyed watching their faces as they reacted to good and bad cards. One of the first rules I had to instil was teach them to only lose a little if they were going to lose so that they could hang on until they got good cards. Despite the incredible satisfaction of stealing a hand, bluffing is by no means a sustainable way of playing!

In order to win, you first need to survive, which is where risk management becomes essential. Surviving means preserving capital and savings, which is fundamental to be able to win at the market. I realised this back during the 2008-2009 crisis. Stock exchanges around the world, including the United States, Europe and emerging countries, all tanked by at least 50%, plummeting to historic lows in 2009.

Counting the end of the present year, the subsequent recovery has been approximately 60%. For investors who preserved their capital, the subsequent gain could be 60% or even more if the right choices were made. However, investors struck by the previous fall had a gain of 30%, thus only preserving half the capital. I therefore suddenly found myself, like so many others who managed to protect capital by free mandates, climbing at double the market rate.

The falls in 2008 were generalised and mostly occurred because of liquidity problems: losses in A need liquidity, and so we have to sell B, which in turn plummets. Losses in B then need liquidity, a need that causes sales in C, etc. As proven by the recovery in subsequent years, the falls had little or even nothing to do with the basic resilience of the businesses in many cases. However, one must survive in order to thrive… And this is where risk management’s role is so critical: preserving capital enables investors to take better advantage of irrational market behaviours.

At Cobas, we always talk about assuring patience with the long haul, i.e., not investing what you need in the short term.

Risk management is the other side of the coin in asset management. It is mostly a continuous exercise in humility at many levels, regardless of the investment mandate: appropriate time to wait/time horizon, measurement with a margin of safety, business and sector tracking, investment diversification, relative weighting of the positions and selling errors.

First, at Cobas, we always talk about assuring patience with the long haul, i.e., not investing what you need in the short term. Because, even when our investment thesis is formulated properly, we cannot predict whether the market will take a month, a year or even longer. We thus give ourselves a bit of margin, and if the thesis still hasn’t worked after a period of three to five years, we accept that we were wrong. This sort of risk management lies in the hands of fund manager and also their investors.

Second, the margin of safety also entails another exercise in humility at two levels: firstly, by opting to invest in companies only when their potential upsides are sufficiently high (and only when we can understand them well). So, if we commit an error and the investment is only worth half of what we initially thought, we can still preserve our capital. For instance, if we were to wait for 100% returns and it is worth half (200/2 = 100) or, in other words, the initial capital, we wouldn’t lose anything except the opportunity cost.

Third, because our valuation is based on conservative premises. We therefore preferentially gravitate towards solid and established businesses, humbly refraining from entering the arena of exponential growth and new trends, where anything could happen. We’ll leave that to braver risk-takers.

Fourth, while the tasks of formulating the investment thesis and initial valuation are highly formidable, tracking the business, sector and managers of our companies is by no means any less arduous. Investing thus requires exclusivity. This is an essential phase to change and even correct errors in the original thesis and take steps accordingly. The work, however, does not and will never end there. In fact, no investment is a masterpiece to be proud of. On the contrary, after creating a portfolio, perhaps 75% of work entails tracking the ideas in the portfolio.

Fifth, diversification appeals to pure common sense, namely not hoarding all your eggs in one basket. Asset management means having adequate material investments so that their impact is relevant and greater than the liabilities, yet sufficiently diverse so you can preserve capital and continue investing in case of error. Once again, even when we are fully convinced of the soundness of a business and its valuation based on conservative premises, quality of the managers, assets in the balance, etc., we should always bear in mind that anything can still happen and that a “cautious (humble) man is worth two.”

Tracking businesses and managers should help us calibrate how close or far we could be from crystallising our theses, and the barriers and fears that the market must still overcome. Likewise, the performance of market share prices will fluctuate the potential of the different companies. In light of the foregoing, what makes some more attractive than others will continue changing, and we must therefore continue adapting our positions and diversification, with greater weight on companies that provide a better return-risk tradeoff.

Finally, the sale of failed investments or errors is one of the greatest signs of humility. An error will be something whose investment thesis will not be fulfilled, where no money will be gained, or where the risk of loss has increased. The most important aspect here is that the fieldwork, i.e., the process, was solid enough to get it right most of the time and fail only occasionally. However, errors are painful emotionally and we all interpret them, at least unconsciously, as a “job done wrong.”

For this reason, human nature has created a plethora of barriers and biases in our behaviours such as risk aversion, tendencies towards confirmation and representativeness, familiarity and many other such biases.

That said, we should also be capable of accepting an error, resetting the meter and viewing every investment as what it really is now. Besides, maybe a past error will open the door to a great opportunity, or maybe it won’t. It is absolutely essential to be free of any emotional baggage in order to invest.

Rushing headlong, bluffing and going for broke do not work in the market. Only meticulous work, character (stamina and humility) and patience do.

Risk management is part of the investment process. It is much more difficult to appreciate than simple figures on daily/monthly/annual returns. However, I believe that it is much more important: while anyone can win 100% at a casino, how do we know if it was all about luck (betting everything on red) or a repeatable skill? This is why institutional due diligence spend their time and efforts on understanding and checking investment processes at asset management firms.

In any case, however, the passage of time also applies an implacable filter and puts everyone in his or her place eventually. And only the ones who properly manage the risk live to tell the tale.