Reducing risk is a critical part of the investment process, and an integral part of value investing. Benjamin Graham was one of the first to lay out the idea of risk not as volatility, but as the chance of permanent capital impairment. But even today, Wall Street still defines risk as volatility, which is itself a consequence of uncertainty.
It is vital for value investors to be able to distinguish the difference between risk and certainty. Unfortunately, it is not easy to do so.
Establishing whether or not a company is actually a risky investment or just facing an uncertain future requires plenty of work and research. There is just no shortcut.
Another issue is that low-uncertainty businesses are not necessarily low risk for the investor. A company's outlook might appear to be bright and predictable, but we never really know what's around the next corner and whether or not there is an underlying skeleton in the closet that might ultimately turn the low-uncertainty business into a disaster zone.
So, how do you determine the difference between uncertainty and risk?
Investor Mohnish Pabrai (Trades, Portfolio) has written several articles and blogs on this in the past and has developed a straightforward framework for investors to follow for determining the difference between uncertainty and risk.
Pabrai's approach is based on research you need to know and understand the company you are looking at before putting the figures into the framework. One fantastic historical example is that of Stewart Enterprises back in the early 2000s. While the rest of the market was booming, thanks to the dot-com bubble, this death care business was suffering because it was a highly leveraged enterprise. As Pabrai wrote in an article on the stock in 2001:
"The reason was that Stewart is a leveraged company with a lot of debt. About $500 Million of that debt was coming due in 2002 and there was no clear answer in July 2000 as to how the company was going to pay it. Wall Street assumed the company may have to declare bankruptcy when it defaulted on its debt and tanked the stock to under $2/share (from $28/share)."
Closer analysis revealed this uncertainty did not translate into excessive risk. The value investor concluded that there were three possible scenarios for the business over the following 24 months, each of which would allow it to reduce debt substantially. In all of these scenarios, Stewart Enterprises appeared undervalued.
In the first scenario, Pabrai assumed that the death care business could sell 50 to 100 of its rolled-up funeral homes to pay back its outstanding debt. As the company had acquired these businesses from owner-operators in the first place, Pabrai believed these would be willing buyers in a distressed situation.
There was also the possibility that bankers might extend the company's debt maturities based on its predictable cash flows and robust business model.
In the third and final scenario, Pabrai assumed that the business would collapse, but even in this worst-case situation, selling funeral homes could generate enough capital to pay off creditors substantially, leaving plenty of equity for investors.
After analyzing these three situations, he concluded:
"Even under scenario 3, the stock was mispriced at $2/share. Once one of the above scenarios unfolded, I thought that the uncertainty would go away and the stock would go to 10 times cash flow or $7-8/share. The Pabrai Investment Funds bought Stewart at about $2/share in Q3 and Q4 of 2000 with the intent of exiting at anything over $4/share within 2 years."
Put simply, in this situation, the uncertainty was high, but the risk of a permanent capital impairment was low. As it turns out, the company decided to sell some of its funeral homes at the beginning of 2001, and the stock jumped 100% in less than nine months for Pabrai Funds.
Situations like this are rare, but they present the perfect opportunity for value investors to take advantage of, as Pabrai concluded:
"Wall Street could not distinguish between risk and uncertainty and got confused between the two. Savvy investors like Buffett and Graham have been taking advantage of this handicap that Mr. Market possesses for decades with spectacular results. Occasionally, you’ll see a company like Stewart which shows three interesting characteristics – Low Risk, High Uncertainty and High Return Possibilities. The combination of these three attributes at the same time in the same company makes for some very satisfying investing returns. Take advantage of Wall Street’s handicap!"
Disclosure: The author owns no share mentioned.
