Why risk management is an insurance policy

By Morningstar |  07-11-19 | 

Rupal Bhansali, Ariel Investments' chief investment officer of international and global equities, has some brilliant insights on the subject of risk.

She engaged in a long conversation with Jeff Ptak, Morningstar’s global director of manager research, and Christine Benz, Morningstar’s director of personal finance. 

Here is an extract on the aspects of risk in investing.

Because I'm an equity investor, I am long risk.

Equity investors are the risk bearers of first resort in the cap structure. As an equity investor, you have to keep risk front and center. 

Risk is a costliest cost, in the sense that if you have an investment portfolio that's worth $100, and if it declines 50%, now you're starting at $50. In order to make up for what you lost, even if you have an idea that goes up 50%, because you lost 50%, when you make 50%, you're only back to $75. That's the power of compounding that you always lose money from a higher number 100, but you make money from a lower number 50. Now, you need to come up with a 100% idea to just break even.

Imagine if you lost less money.

Let's say that $100 portfolio only declined 20% to $80. And now, if you have 100% idea to invest in, and you put it to work in that $80, you're now making $160, i.e., you've delivered 60% capital appreciation as opposed to the drawdown that you would experience if you lost a lot of money. 

So, compounding means that avoiding losers and losses is more important than picking winners and making gains. And it's because of that arithmetic that every investor whether they are conscious of it or not, the arithmetic of compounding dictates that you pay more attention to losers and losses.

We're extremely risk-aware, because risk proves to be much more costly, because you lose from a higher number, you make from a lower number. 

We look at how much a stock can go up. We also look at what can go wrong, and stress-test the downside.

Sometimes we will own stocks which may not have a lot of return but have very limited risk. We pay attention to both simultaneously. 

It's entirely possible that Berkshire Hathaway (a top-10 holding in Ariel Global) may not have the same upside potential as, say, Michelin, but has less downside risks potentially.

We run a relatively concentrated portfolio-- the top 10 holdings can account for a significant portion. One way to diversify the concentration risk is to be diversified into investment thesis. 

The thesis underpinning Berkshire Hathaway and the business model of Berkshire Hathaway and the underlying drivers of what's going to cause that business to perform, is completely different from Microsoft, which is completely different from Glaxo, which is completely different from Michelin. All of these investment theses stand on their own merits from a risk and reward standpoint.

That's what I mean by we will own stocks with very diversified investment theses. But that does not mean a diluted investment thesis, it's a high conviction in everything that we own, in whatever position size we own it. 

Risk management is an insurance policy.

When things are performing well is when an active manager has to make a decision whether to stay away from it. This is why we started selling our banking stocks in 2006. Consequently, we had spectacular performance in 2008 when a lot of investors lost their shirt. We did not just admire the growth rates (growth investor) or low multiples (value investor). We paid attention to risk.

People think that managing risk is like a minute before midnight some clock is going to go off and tell you, go buy risk protection. It doesn't work that way in the real world.

We think about risk in a very holistic way. Valuation risk. Business-model risk. Regulatory risk.

Identifying risk is a mosaic, not a formula.

Investing has become far more sophisticated, far more global in nature.

So, what Toyota tells us, we try to validate with whether the Volkswagen and GM are saying the same thing. And if it's disconnected or disjointed, it's our job to figure out what's the truth.

And so, from that perspective, this global sector research--you know, a lot of investors in the U.S. were taken aback by deflation. They had never experienced it; they didn't know how to think about it or deal with it. But as global investors who cover 50 countries around the world, we have experienced deflation. 

Japan was the first country in the world to do QE. we knew that one of the sectors that would be really badly affected is banking. Japanese banks have never really reclaimed their former glory. Now, they are surviving, but not thriving. And that's exactly the playbook that is playing out in Europe, which has hurt a lot of investor portfolios.

Without this macro awareness, this larger playbook in your head based on experience and expertise, it's extremely hard to connect the dots. 

There is the business-model risk and the risk where the business is fundamentally changing.

In Consumer Staples, the business model is fundamentally changing. People think of it as a very safe defensive quality sector. Look at Kraft Heinz. There was a business-model risk that manifested itself in financial leverage risk that is now manifesting itself in stock valuation risk. They are not able to generate enough revenues. They are not able to cut their E&P costs. Once your product does not appeal to the consumer, it's going to show up in the numbers, it's going to show up in the stock price. So, if you had understood what was going on in the Kraft Heinz business, the rest would have followed suit. 

A similar thing is playing out in Apple. Apple's flagship product, iPhone X did not sell well. Yet people look at Apple from the lens of yesteryears, thinking of it as a technology company, with its ecosystem, et cetera. Well, once your flagship product starts to disappoint, your entire ecosystem has a challenge, because services revenue, which is what people are pinning their hopes on, is a function of the installed base, which is shrinking.

A lot of people argue that they will never give up their iPhone. Well, I'm not asking you to. It's a treadmill, a consumer electronics company like Apple, which is to say that, if you don't sell a new piece of hardware, there is no revenue that you book. So, all that has to happen is the replacement cycle of an iPhone has to extend itself from, say, 2 years to 3 years and that's a third less in revenues. That's not a stretch at all. 

So, in the case of Apple, people think it's a low-risk, high-quality business model. And we would argue it's the opposite. And there is a very high amount of business disruption risk for that company, partly because of this lawsuit that's now coming up where Spotify and others are suing the company for acting monopolistic in terms of the distribution platform that it offers, and the pricing that it charges for it.

It's got competitive risks, because the competitive profile, the specs of the iPhone are not as competitive vis-à-vis the Samsung Galaxy, vis-à-vis Xiaomi's phones, and other phones in the Chinese market, which is a big source of incremental growth for them, and they are priced a premium without having premium specifications that compete effectively. 

All this is not manifesting itself in the numbers. But that's exactly the setup for a Nokia back in the day. That's exactly the setup for a Blackberry back in the day. We were all addicted to these things. We cannot imagine a future without a Blackberry. And yet, as time has passed on, we saw consumer electronics companies tend to be hit or miss. And that's what Apple is. It's a consumer electronics company. It is not a software company as people would like to believe. 

Microsoft is a software company. And we cannot do without Outlook and Excel and PowerPoint and Word. And every month, we're going to pay a subscription revenue for it.

All tech companies are not the same, and the market needs to figure out where is the risk and where is the reward.

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