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:
- Be adequately diversified.
- Hedge positions “when appropriate and when not expensive.”
- 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:
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.)
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