In our investing world, high returns get all the glory; as Howard Marks (Trades, Portfolio) explained, that’s why high-returning investors get their pictures in the papers.
But in his mind and in his book, “The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor,” he thinks high returns on their own are misleading and risk control is not properly appreciated. In fact, he thinks the great investors are those who take risks that are less than the returns they bring in. Great investors are those who achieve “moderate returns with low risk, or high returns with moderate risk.”
As to those who get their pictures in the papers for high returns, can they do it for many years? Marks’ point being that achieving high returns with high risks is meaningless without the ability to do it consistently, year after year.
Among the few who can do it consistently are Warren Buffett (Trades, Portfolio), Peter Lynch, Bill Miller and Julian Robertson (Trades, Portfolio). Not only did they have excellent returns, but they were relatively consistent and had no disasters. They controlled their risks and, while they may have a bad year or two, overall they have an above-average record.
Ironically, there are few awards for good risk control because risk is generally invisible. The obvious sign that risk was present is a loss, large or small. Still, just because no loss occurs does not mean there was no risk—it’s more likely risk was present, but no adverse events occurred to trigger a loss.
Marks goes on to argue the absence of loss does not mean a portfolio was safely assembled, it just means its manager was lucky. “Only a skilled and sophisticated observer can look at a portfolio in good times and divine whether it is a low-risk portfolio or a high-risk portfolio,” he wrote.Â
A good manager, then, is someone who can reduce risk for a given return. He cited Buffett’s saying, “You only find out who is swimming naked when the tide goes out.“ Those swimming naked are, of course, those who have not controlled their risks. More broadly, it means no one knows who is controlling and who is not controlling their risks during up markets or placid times.
The author also wrote, “When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.” To explain the idea of intelligently bearing risk, he uses life insurance companies as an example:
- They know everyone dies eventually, so they know there is risk present.
- The risk of any one individual dying can be objectively analyzed, with a doctor’s assessment.
- Diversification is used to reduce risk by having a mixed group of policyholders.
- Policyholders will pay them well to take on this risk. And absent “black swan” events, the companies should make money.
For professional and amateur investors, risk can be controlled through the price paid. Marks wrote, “I’ve said for years that risky assets can make for good investments if they’re cheap enough.” This is another reason why Marks is considered a value investor.
Distinguishing between “risk control” and “risk bearing” is also on Marks’ agenda, as is the distinction between “risk control” and “risk avoidance.” Risk bearing is not something investors can avoid, it is an inherent part of investing. The ideal is to do it at the right time and to do it well.
Risk avoidance must be intelligently applied because it can turn into “return avoidance”. As the author wrote, “Risk control is the best route to loss avoidance.” In concluding chapter seven, he also said, “Skillful risk control is the mark of a superior investor.”
For a more pragmatic approach to risk control, we turn to Thomas Macpherson, a GuruFocus contributor and author of “Seeking Wisdom: Thoughts on Value Investing.” He uses a process he calls “breaking the investment case” to quantitatively assess a company’s risk. As the name suggests, he starts by developing a case for investing in a stock, but then deconstructs it using his own stress tests.
This starts with a series of potential black swan events that reduce revenue. He then applies revenue reductions of 10% to 70%. At some point in that series, the company will transition from surviving to expiring. In his words, it is “getting to zero.” He follows up by doing the same with free cash flow growth estimates, halving them and looking at the impact on valuation, financial strength and so on. After that, he halves it (free cash flow) again.
Macpherson explained, “Why do this? To me it’s a simple – and ruthlessly effective – tool in creating a scenario that tests the financial limits of a potential holding.” His example involved CBOE Holdings (CBOE, Financial). It had been growing its free cash flow by an average of 14.3% annually over the previous five years. What would happen if its cash flow growth dropped to 7.1%? Halve it again to 3.5% and review the impact; would it have enough financial strength to handle such catastrophic events?
He added there is more to breaking an investment case than just the numbers, writing, “breaking an investment thesis is as important as building one. I’ve found that I am far more receptive to data for having taken both sides. Cognitive dissonance is less, ego and bias’ impacts are reduced, and I see the company’s actions in a far different light.”
Theoretically and practically, if I am not mistaken, buying a company at a discounted price should also make it more robust, more able to withstand the rigors of stress testing. The mathematics of the price-sales and price-cash flow ratios should be favorably affected in both cases.
Two gurus, two ways to control risk. For Marks, it involves buying at the right (discounted) price, while for Macpherson, it involves stress testing a company’s revenues and free cash flows. Ultimately, they get to the same place: recognizing and controlling their risks.
(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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