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Robert Abbott
Robert Abbott
Articles (462)  | Author's Website |

Modern Value Investing: Focus on Risk, Not Returns

Risk means something different for value investors

January 11, 2019

Value investors should not follow academics and Wall Street when they define risk, according to author Sven Carlin in chapter three of “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment.”

Instead, he urged them to use a value investors’ definition, which is the likelihood of permanent capital loss.

“The first thing a value investor thinks about when investing is not the expected return, but the risk of an investment," he wrote. "By focusing on keeping the risk minimal, you can really find investments that have low or even no risk and offer extremely positive returns. Usually, the lower the risk, the higher the return.”

In the rest of the financial community, risk is usually defined as the volatility of an investment, the amount of variability between highs and lows, and measured with standard deviation. Carlin said the problem with standard deviation models is that they can be manipulated by picking different time periods. For example, a data set that includes the 2008 financial crisis will look much different than one that begins in 2009 or 2010.

Carlin also disputed the idea that higher risk is linked to higher returns, and vice versa, saying, “What determines your return is never risk but something much simpler; price.” When value investors see higher variability, they also see opportunities to buy when stocks are cheaper than usual. Entry at a lower starting point means greater opportunities for capital appreciation.

Of course, value investors want to buy at a discount (margin of safety) to intrinsic value. Carlin wrote, “This is why the most important measure of risk for a value investor is the price he is paying in relation to the value he is buying. That’s it. The lower the price is, the lower the risk is. What happened in the stock market in the last month or year has nothing to do with the risk of an investment.”

Enter black swans, an idea introduced by Nassim Taleb in the book, “Fooled by Randomness.” A black swan is a rare event that has an extreme impact; it is not easy to predict in advance, but seems to have been predictable in retrospect.

According to Carlin, a black swan kills all the assumptions that kept the financial world stable, leading to new assumptions, and can have “huge repercussions” on the prices of assets. These results can be devasting for other investors. While value investors are not immune, they can at least find some protection by buying assets with actual value in relation to the price, a margin of safety.

Next, the author provided his definition of risk: “A value investor defines risk as the probability and the potential amount of loss and therefore the risk of an investment is the probability of an adverse outcome.”

At the same time, a complete understanding of risk would require knowing how an investment works out in the future. That would also require knowledge of the future, which is unavailable. However, Carlin had three potential, counteractive measures to protect against black swans:

  1. Be adequately diversified.
  2. Hedge positions “when appropriate and when not expensive.”
  3. Always invest with a margin of safety.

Following up on the third point, he wrote that while it is impossible to avoid market volatility, value investors can avoid overpaying and avoid companies that have declining fundamentals. Good value at a discounted price means low risk because, in the long term, the value will be reflected in the price.

Carlin also discussed a contrarian idea from Seth Klarman (Trades, Portfolio): A declining stock price can increase long-term returns. For example, an investor buys a stock with a price of $10 and a dividend yield of 5%. The following year, the price drops to $5 while the fundamentals stay the same and the investor reinvests the dividend, so the ultimate return will be higher. He created this table to illustrate:

Sven Carlin - Seth Klarman

After three years, a one-year, 50% decline in the stock price increased the total return by 31%. Quite the silver lining—for an investor focused on the long term.

The final conceptual issue in this chapter is asymmetrical risk and reward. Positive asymmetry means the amount that can be lost is less than the potential return; negative asymmetry means the potential for loss is greater than the potential gain.

Obviously, investors who fill their portfolio with positive asymmetric risk-reward investments should enjoy relatively high returns for very little risk—the objective of value investing.

For many investors, the problem is a focus on returns rather than risks; a problem that is exacerbated in bull markets. In Carlin’s view—he wrote this in late 2017—the bull market was growing old and he strongly expected a recession in the next five years. Investors are buying at high prices, and those prices will likely take a big hit in the near future, thus creating a negative asymmetry. Based on a theoretical case and his calculations, investors would be risking $50 for a potential return of $27.

It is not easy, but value investors can find positive asymmetry. Carlin referred to fundamental risk indicators, such as book value, stable cash flow and cash per share, that limit downside risk. At the same time, they should be looking for disproportionately high return potential for the upside.

He also suggested a qualitative factor, which is growth.

“A company that has a high probability of long term sustainable growth due to positive industry circumstances, macro or demographic trends, will potentially deliver much higher returns than companies with relatively high debt burdens constrained by a slow growing economy like as is the case for many constituents of the S&P 500,” he wrote.

How do investors find such companies? Carlin advised that the more stocks they analyze, the more positive situations they will find. The process is made easier when they look at situations where few analysts follow a stock, as is sometimes the case with small caps and foreign stocks.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Read more here:

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution." In his book, "Big Macs & Our Pensions: Who Gets McDonald's Profits?" he looks at the ownership of McDonald’s and what it means for middle-class retirement income.

Visit Robert Abbott's Website

Rating: 5.0/5 (5 votes)



Thomas Macpherson
Thomas Macpherson premium member - 2 months ago

Completely agree Bob. I think far too many value investors focus low key measures (P/E, P/S, etc.) and high discounts to intrinsic value rather than what is the risk of permanant capital impairment. I wll be publishing a series of articles on fundamental business analysis and how to use it to reduce risk and improve your understanding of growth potential. Great summary Bob. Love these reviews. Best - Tom

Batbeer2 premium member - 2 months ago

Thanks for the article.

In my view it is not a matter of using the "correct" definition of risk. Use them all but distinguish between them and take appropriate measures for each.

Take volatility/market risk. Don't deny it is a risk. Volatility gets a lot of smart investors in trouble by turning them into forced sellers and thereby causing permanent loss of capital. Not only because they are using leverage but also because they are managing other (not so patient) people's money. So the appropriate measure is to sit on excess cash at all times and invest only your own money. That turns market risk into a source of excess returns (like in the example you provide).

Another way to put it is that instead of being vulnerable to market risk, you become market risk. It is a zero sum game; you are taking other people's money. But to do that well, you have to understand what it is... which is my point.

Same with currency risk, interest rate risk etc. etc. Understand what they are, how various market participants tend to respond and how they affect long-term owner earnings; then act rationally.

Just some thoughts.


Thomas Macpherson
Thomas Macpherson premium member - 2 months ago

Great points Batbeer. Thanks for sharing them. - Tom

Robert Abbott
Robert Abbott premium member - 2 months ago

Tom and Batbeer2, thanks for your comments!

Readers, there is a link at the end of Batbeer2's comment leading to an article on the 9 types of investment risk. I would also recommend it, and, please take his advice to learn about each and all of them, and how they might affect your outcomes.

Also watch for Thomas Macpherson's upcoming articles on fundamental business analysis; his articles always insightful and easy to read.

Robert Abbott
Robert Abbott premium member - 2 months ago
LwC - 2 months ago    Report SPAM

“After three years, a one-year, 50% decline in the stock price increased the total return by 31%. “

In the table above that, it looks like the return is 21%.

Robert Abbott
Robert Abbott premium member - 2 months ago

Good catch, LwC!

Carlin does refer to 21% in the table and 31% in the text. I'm not even sure where he got those percentages; my calculator says 27% (Total reinvested dividend + End of year value) - (starting value of $10,000) = $2,705 / starting value = 27%

Anyone, especially Klarman followers, got ideas about this?

LwC - 2 months ago    Report SPAM

Reading your response inspired me to take another look:

21% scenario B total return minus 16% scenario A total return equals 5 percentage points.

5 percentage points divided by 16% equals 31%.

The ending year value for scenario B year 2019 reflects the additional shares purchased in 2018 at $5, plus the end of year dividend.

**edited to correct ommission of "16%" in second line

Robert Abbott
Robert Abbott premium member - 2 months ago

Well done, LwC!

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