Don't worry about risk if you know the business's value
AVNER MANDELMAN Saturday, July 1, 2006
On Wednesday night my 15-year-old son won first prize in entrepreneurship in the Greater Toronto Area for a detailed business plan to minimize raccoons' nuisance to a home. Several of his friends won prizes too. It brought to mind how more than a year ago his teacher invited me to speak about "value investing."
The kids were a bright lot, but when I asked how they defined "risk," they used theoretical concepts such as beta, correlation and volatility. Now, I use some math myself, but to a value investor risk is more than math -- it is the difference between price and value. How to explain it? Imagine, I said, that a company's sole asset is a condo building with 10 units, each with a market value of $100,000. The company is publicly traded and there are one million shares outstanding. What's the intrinsic value of the shares? Right: $1 a share, because if you bought all shares you could sell the condos and get this value.
Now assume there's a rumour that deceased raccoons were found inside the building's walls and an expensive renovation is needed. The stock swoons to 75 cents. You hop on the subway to check the building and find only two baby raccoons strolling in the basement, none resident in the walls. The city inspector confirms the building is fine.
So, based on your research, you buy shares, and make money when they climb back to 95 cents. This, I concluded, is what value buyers do. But where's the risk here? It is certainly not in the price volatility.
Finally, one kid piped up: The risk is asbestos in the walls, not raccoons. Exactly, I said. The risk is in ignorance of the facts. But if you check things out, why should you care about the upsy-downsy movement of the stock price?
Which brings me back to the topic of risk, a concept most investors think they know, but may not have thought through. You may be surprised to learn that for certified financial analysts, academics, financial advisers and others who assimilated modern portfolio theory, risk is basically the "squiggliness" of the price line. But is it really? Or is this just the risk of losing sleep?
Take for example Berkshire Hathaway -- Warren Buffett's flagship company. During 1998-2000, the stock fluctuated wildly between $80,000 (U.S.) and $40,000 a share, up and down. At roughly the same time, the stock of a certain mining scam, where local warlords had salted the lab rock samples, was going straight up (because no one had found out about the scam yet). Based on modern portfolio theory, at that period Mr. Buffett's stock would be seen as riskier than the mining scam, because its price wiggled more.
What of the fundamentals? Or underlying assets? About this the theory is silent. Now, this is not an idle point -- most investment portfolios are constructed using the price squiggliness as a surrogate for risk, because economists who won Nobel Prizes define "risk" this way, mathematically. (Indeed, how can you express "dead raccoons in walls" in a mathematical formula?)
But then, if you don't use math, how can you measure risk? Ah. Depends who is doing the measuring. You see, the market is composed of two types of people: agents and principals, and the two see it differently. For the first, it is the risk of losing money; for the second, of losing their job. That's why the first (like Mr. Buffett) usually define risk (and investment) in terms of underlying value, while the second (brokers, advisers) define it in terms of clients' sleeplessness. When you invest your own money based on your own due diligence, if shares you bought at 70 cents drop to 60 cents, you're likely to see a bigger bargain, and perhaps buy more. But if a money manager did it, his clients might yank the account and so force the manager to sell the shares (most likely to a principal investor).
This is something that savvy market pros know and that neophytes take years to learn: Principals make money when agents panic and hand them value bargains. That's why the best money managers (which is what this column is concerned with) often behave like principals -- they buy value and accept price squiggliness (also known as drawdowns) as a fact of life.
Mr. Buffett did not flinch when BH's stock fell significantly in 1999. (Of course, it helped that he controlled the company.) An excellent value manager who appeared in this column noted that 30-per-cent drawdowns are something he'd accept -- and had. (Giraffe, another value investor, had levels of about half that in the past.)
Another excellent money manager who appeared here had taken drawdowns but keeps investing according to value, with a focus on physical due diligence.
What should it mean to you? That if your investments are down after the past few weeks, the best solution to your angst is to measure the value you own, and if it is still ample, ride it out. Just like that condo building -- if you know the value of each unit, some raccoon rumours won't faze you.
But what if you find you don't know the true value of what you own? Then you should either find it out, or invest in something else whose value you do know. Because only deep knowledge of value can both make you money and safeguard your sleep.
Avner Mandelman is president and chief investment officer of Giraffe Capital Corp., a Toronto-based money management firm.
amandelman@giraffecapital.com
On Wednesday night my 15-year-old son won first prize in entrepreneurship in the Greater Toronto Area for a detailed business plan to minimize raccoons' nuisance to a home. Several of his friends won prizes too. It brought to mind how more than a year ago his teacher invited me to speak about "value investing."
The kids were a bright lot, but when I asked how they defined "risk," they used theoretical concepts such as beta, correlation and volatility. Now, I use some math myself, but to a value investor risk is more than math -- it is the difference between price and value. How to explain it? Imagine, I said, that a company's sole asset is a condo building with 10 units, each with a market value of $100,000. The company is publicly traded and there are one million shares outstanding. What's the intrinsic value of the shares? Right: $1 a share, because if you bought all shares you could sell the condos and get this value.
Now assume there's a rumour that deceased raccoons were found inside the building's walls and an expensive renovation is needed. The stock swoons to 75 cents. You hop on the subway to check the building and find only two baby raccoons strolling in the basement, none resident in the walls. The city inspector confirms the building is fine.
So, based on your research, you buy shares, and make money when they climb back to 95 cents. This, I concluded, is what value buyers do. But where's the risk here? It is certainly not in the price volatility.
Finally, one kid piped up: The risk is asbestos in the walls, not raccoons. Exactly, I said. The risk is in ignorance of the facts. But if you check things out, why should you care about the upsy-downsy movement of the stock price?
Which brings me back to the topic of risk, a concept most investors think they know, but may not have thought through. You may be surprised to learn that for certified financial analysts, academics, financial advisers and others who assimilated modern portfolio theory, risk is basically the "squiggliness" of the price line. But is it really? Or is this just the risk of losing sleep?
Take for example Berkshire Hathaway -- Warren Buffett's flagship company. During 1998-2000, the stock fluctuated wildly between $80,000 (U.S.) and $40,000 a share, up and down. At roughly the same time, the stock of a certain mining scam, where local warlords had salted the lab rock samples, was going straight up (because no one had found out about the scam yet). Based on modern portfolio theory, at that period Mr. Buffett's stock would be seen as riskier than the mining scam, because its price wiggled more.
What of the fundamentals? Or underlying assets? About this the theory is silent. Now, this is not an idle point -- most investment portfolios are constructed using the price squiggliness as a surrogate for risk, because economists who won Nobel Prizes define "risk" this way, mathematically. (Indeed, how can you express "dead raccoons in walls" in a mathematical formula?)
But then, if you don't use math, how can you measure risk? Ah. Depends who is doing the measuring. You see, the market is composed of two types of people: agents and principals, and the two see it differently. For the first, it is the risk of losing money; for the second, of losing their job. That's why the first (like Mr. Buffett) usually define risk (and investment) in terms of underlying value, while the second (brokers, advisers) define it in terms of clients' sleeplessness. When you invest your own money based on your own due diligence, if shares you bought at 70 cents drop to 60 cents, you're likely to see a bigger bargain, and perhaps buy more. But if a money manager did it, his clients might yank the account and so force the manager to sell the shares (most likely to a principal investor).
This is something that savvy market pros know and that neophytes take years to learn: Principals make money when agents panic and hand them value bargains. That's why the best money managers (which is what this column is concerned with) often behave like principals -- they buy value and accept price squiggliness (also known as drawdowns) as a fact of life.
Mr. Buffett did not flinch when BH's stock fell significantly in 1999. (Of course, it helped that he controlled the company.) An excellent value manager who appeared in this column noted that 30-per-cent drawdowns are something he'd accept -- and had. (Giraffe, another value investor, had levels of about half that in the past.)
Another excellent money manager who appeared here had taken drawdowns but keeps investing according to value, with a focus on physical due diligence.
What should it mean to you? That if your investments are down after the past few weeks, the best solution to your angst is to measure the value you own, and if it is still ample, ride it out. Just like that condo building -- if you know the value of each unit, some raccoon rumours won't faze you.
But what if you find you don't know the true value of what you own? Then you should either find it out, or invest in something else whose value you do know. Because only deep knowledge of value can both make you money and safeguard your sleep.
Avner Mandelman is president and chief investment officer of Giraffe Capital Corp., a Toronto-based money management firm.
amandelman@giraffecapital.com
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