Every investor faces risk and uncertainty. Examining the news flow each day, one could be forgiven for perceiving these risks are mounting ever higher. Macroeconomic and political risks from Brexit & US-China trade relations dominate the headlines, while the business pages feature industry disruption, lower retail footfall and stock market volatility.
Meanwhile, climate change has seen a surge in droughts and flooding globally[1], and the rise in populism[2] is threatening the very fabric of Western democracy. All that before we even consider the risks from behavioural biases we often subconsciously impose on ourselves when investing. But before throwing in the towel and retreating to our basements for shelter, investors should take a step back and try to understand what risk is, what it isn’t, and most importantly, how to adapt their investment processes to appropriately take risk into account.
If the return to the investor is a measurement of what did happen, risk can be considered as the distribution of all the potential outcomes that could have occurred. Investors are, understandably, usually more concerned with downside risk. For the equity investor, this is the risk that a company underperforms, the share price declines and capital is lost. So given this understandable fear, why take any risk at all?
Risk as an art form
Generally, the higher the risk of an investment the higher the potential return. This can be observed by comparing the results of investment in both small and large cap companies. Small cap or early stage companies offer the potential for higher returns, but generally have a higher probability of failure. In the equity market, the share price is set by the market of sellers and buyers.
Given perfect knowledge of share returns and probabilities, arbitrage should efficiently set the prices to compensate investors for the risk faced. However, risks that may affect the returns on an investment are numerous, varied, ill-defined and unpredictable.
This generates a layer of uncertainty over all investments; obscuring risks, manipulating views of probabilities and turning investment from a simple game of mathematics into an artform of quantitative and qualitative assessment. For active investors, this provides an opportunity to make a profit, but one must concentrate not only on loudly promised returns but also quietly whispered risks.
So, how do investors approach the assessment of risk? To model the risk of investing in a company, investors often consider the standard deviation of historic returns as a proxy. This relies on two key assumptions, firstly that the distribution of returns is normally distributed and secondly, that the historic volatility is a good representation of variability in the future.
Assumption of a normal distribution has notably been discussed by Nobel prize-winning Professor Gene Fama[3], who concludes “distributions of daily and monthly stock returns are rather symmetric about their means, but the tails are fatter than would be expected with normal distributions.” This is important for investors, as fatter tails mean more extreme events or “Black Swans”[4]. This has the potential for more extreme losses and gains for the investor than represented by the distribution. Thus, the proxy underestimates perhaps the most important aspect – risk of permanent capital loss.
You can’t step into the same river twice
The second assumption is also questionable. Historical data represents only the results gained in the economic and political reality of the past. The environment in which any firm operates now is vastly different to a decade ago. Heraclitus’ adage that "you cannot step into the same river twice, for other waters are continually flowing on" applies equally to firms operating environments.
To illustrate this, consider a pharmaceutical company exposed to a new price regulation risk. If no cut has yet occurred and the market has not contemplated it historically, then the historic price shows no increased volatility from the pricing risk. The company may have been steadily increasing prices, earning steady profits with low volatility, while the political will to regulate builds higher. Cue one mistimed comment or tweet from a politician and the risk has a greater impact on the share price and investor returns.
We cannot discount events just because they have not happened before. A further flaw in the assumption comes because the past returns are indicative of what actually happened, not the range of outcomes that could have happened. If a company takes extreme risks and these pay off (possibly fortuitously due to external effects), should we assume the company will continue to make good on risky bets? If a roulette wheel lands on black three times in-a-row, should this affect our belief in the odds of red coming up on the next spin?
If understanding risk is vital to our investment strategy and we accept it’s difficult to identify and measure, then how should we account for it in our actions? We assess risk on a fundamental basis for each company and have built consideration of risk into our investment process at both an individual position and portfolio level. To assess the risks faced by companies we consider for investment, we rationalise the set of risks they may face by deconstructing them into key categories.
These include; industry & competitive risks, related to the company’s economic moat and economic sensitivity; stewardship risks, related to the management quality & social impact; and operational risks, related to balance sheet strength and the ability to generate free cash flow. The latter are particularly important, as a secure balance sheet and additional available cash flow allow the funds for the company to address even unconsidered issues as they arise.
Right-sizing risk
Thinking deeply about the fundamental risks affecting a company gives us an insight into their likely responses to different scenarios. When negative events do occur, this provides us reassurance and helps us better evaluate our response to the news. The importance of each category of risk will differ depending on company type. For example, Pepsi and Adecco are vastly different companies and have a different set of risks. The cyclical nature of cash flows for recruiter Adecco will require the business to operate with a far stronger balance sheet, emphasising the importance of solvency risk.
Having built an understanding of the risks facing companies, we implement a process designed to consider these risks when making our investment decisions. We do this by using a maximum position framework. After considering the risks faced by each company and both the bull and bear cases, we agree the maximum percentage that we would be prepared to hold in the company (ignoring both valuation and yield).
By defining a maximum position per stock, we impose a discipline to carefully consider our portfolio position sizes at the stock level. For good value stocks where our position size is well below the maximum, we are prompted to consider why we do not own more given the relative returns and risks faced. For companies where our holding is above or approaching the maximum position, it prompts us to reconsider risks faced by the company and whether we should continue adding or even reduce position size. These checks not only help us with fundamental risk consideration but make us confront our behavioural biases.
Considering risk at the company level is not enough. The risks faced by different companies are often correlated and so we must also consider the cumulative effect of risk at the portfolio level. If an investor owned 100 oil producers, the portfolio would be diversified by individual company risk, but a cut in the oil price would affect every company and the portfolio overall. At this point we contemplate the diversification effect by exposure to a range of geographies, industries and end-markets. We also focus on quantitative metrics of the portfolio. Managing these ratios helps us to better respond to a wide range of uncertainties. For example, our Global Income portfolio has a free cash flow yield of 5.6% and a net debt to EBITDA ratio of 1.1x[5] - both better than the MSCI World Index’s 4.2% and 1.5x respectively[6]. We believe by managing these ratios we position the portfolio well.
This process is by no means fool-proof[7]. It does, however, give us confidence we will be able to manage the portfolio through uncertain outcomes, and we have considered a wide range of risks in our investment decisions. Vigilance at a fundamental company level and responsible portfolio construction is the most sensible route to generating long-term returns and the best protection in an uncertain world.
Chris Elliott
Co-portfolio Manager, Evenlode Global Income
[1] Nature 2018, https://www.nature.com/articles/d41586-018-05849-9
[2] Populism and the economics of globalization, Dani Rodrik, Journal of International Business Policy
[3] Q&A: Are Stock Returns Normally Distributed? Eugene Fama & Kenneth French. https://famafrench.dimensional.com/
[4] Black Swans, Nicholas Taleb
[5] FactSet, 9th January 2019
[6] FactSet, 9th January 2019
[7] Though this always reminds me of my favourite quote - “A common mistake that people make when trying to design something completely fool-proof is to underestimate the ingenuity of complete fools.” Douglas Adams – Hitchhikers Guide to the Galaxy
