Os dejo otro buen artículo de Von Wys: http://www.bwm.ch/

Risks and how we handle them

Investors who hold investment funds are exposed to a variety of risks. In this article, the first of two, Braun, von Wyss & Müller describes the firm-specific risks and the measures to mitigate them: analysis, the “margin of safety,” patience and diversification.


 Georg von Wyss on 24.06.2014

The term “risk” is part of every discussion about investments. Everyone knows what risk means: the possibility of making less money than expected and even losing it. But each person has a different idea of what they regard as risky. That is partly because they may disagree on how likely it is that a risk will manifest itself and how much of a loss it will cause. For investors there is also a third, temporal dimension. A paper loss is not a real loss if one believes it is merely transitory.


In this and the next article we will take a look at many of the risks that we see in holding funds or similar investments and the steps we take to mitigate them. We have grouped the risks into four types, firm-specific (discussed in this article), and next month macro, timing and organizational.


Firm-specific risk: something goes wrong with the investment


Firm-specific risk is the risk that an investment does not perform as expected for reasons that have to do with the investee company. Most of the time the price of investments is determined by their intrinsic value, which corresponds to the time value of the future expected cash flows (see our blog entry from Oct. 21, 2013:  "Growth in value investing").  If these turn out to be less than thought, normally because the company’s business has deteriorated, the fundamental value of the investment falls.


The list of risks that can lower company values is probably infinite. Here are a few. One of the most common is a technological advance that can obsolete a product. This is an acute risk in health care and IT. Another common one is the entry of a lower priced competitor, for example someone making an essentially commoditized good in a low-cost country. An ever-present danger, particularly for retailers and manufacturers of clothing, is that consumers’ tastes change. Governments change tax and other laws as well as regulations, as the financial industry knows all too well. A management can try out new ideas that turn out poorly (e.g. J.C. Penney, where sales halved because of a change in pricing policy!). All of these risks are exacerbated if a company has a great deal of debt, because under these circumstances even merely temporary shortfalls in cash flows can cause otherwise sound businesses to default.


First line of defense: research


Our first line of defense against fundamental risks is detailed research. While we by definition cannot predict surprises, our estimates of intrinsic values can reflect the likelihood and potential impact of some negative occurrences. Therefore, in our analyses we try to understand as well as we can how an industry functions and what a company’s place is within it. We employ a number of tools to ensure that our work is thorough, starting with a highly detailed financial model that analyzes past performance, tracks financial ratios (very important if there is debt) and contains our forecasts. We use a checklist of possible risks. We read the company’s risk disclosures and talk to the management. Naturally we consult the media, but we also seek out competitors and customers, employing so-called expert networks to find sources with their ears to the ground. For example, we recently used this service to arrange conversations with a competitor, customer and former senior employee of one of our companies before speaking to the CEO, all with the idea of finding out what the company’s problems were and what it was doing to fix them.


If the market has already discovered a risk and reflected it in the stock price, then that is an opportunity for us value investors. An example here is the feared substitution of the personal computer by the tablet, a shift in consumption that weighed on the stock prices of our holdings  Intel, Microsoft and  Hewlett Packard. We concluded that this risk was not very probable and that the stocks were in fact cheap (see our blog entry from Aug. 27, 2013:  "Will the tablet kill off the PC ?"). We might also find that a risk has only a limited financial impact, less than the market fears. If the investment is attractive even in a worst case, then we will buy. That includes cases where we owned a stock and were surprised by the risk and, upon doing further research, decided that we wanted to add to the position at low prices, as the bad event had only a transitory effect.


But of course not all risks are opportunities. Sometimes they cause us to avoid a stock altogether, most frequently if the balance sheet is weak, and sometimes we take a risk and get burned, meaning that we have to reduce our estimate of the intrinsic value significantly and permanently. Agfa, a current holding, is a textbook case for everything that can go wrong. The company knew that information technology would kill off its film-based businesses and had developed a strategy to cope. We bought the stock, knowing that there was a risk the transition would not work. It didn’t, to some extent. Management botched the integration of its new healthcare software businesses, in particular failing to develop new versions in a timely fashion. At the same time, the company had terrible luck in that the profitability of its still important film-based business was ruined by a huge jump in silver prices, an important input. While these costs have fallen again, the first factor has reduced the company’s intrinsic value permanently, though it still lies above the current, low stock price.


Second line of defense: margin of safety


The central principle of value investing is buying at a large discount to intrinsic value. As the concept implies, that leaves us a margin of safety against errors in our analyses and, quite simply, bad luck, increasing the likelihood that a new, lower intrinsic value still exceeds the price we paid. We may want to sell at that point, as the stock no longer has potential, but we will not have lost any money. And if the bad news that forced the reduction in the intrinsic value also caused the share price to drop a great deal, creating a new margin of safety, we might even buy more, irrespective of whether he made or lost money with the first purchases.


Third line of defense: patience


When a risk causes a stock to drop without, however, affecting the intrinsic value much, a second line of defense is patience. We value companies based on a normal level of earnings – that is, the earnings they can achieve when the economy is growing at a normal clip. Some risks, commonly economic downturns or maybe firm-specific problems in manufacturing or sales, simply need time to work out.  They do not lower the company’s earnings power and thus the ultimate intrinsic value (though of course the calculation of the present value has to take into account the time necessary for fixing the problems). If we are reasonably sure that the company will not go bust or require a massively dilutive stock issue during this time, we will wait, sometimes for years. Our holdings of temporary employment agency  Randstad is a current example. In our  annual report 2013 we discussed how we sold half this position in late 2009 and early 2010 with a nice gain, but in 2011 we sustained a paper loss of nearly 50% on the other half. Those with a shorter time horizon may have taken this loss, but we did not, because we were convinced that we would get an economic recovery in the medium-term and that the company had significant earnings power in such an environment. Indeed, the stock has doubled since.


Fourth line of defence: diversification


We aim to hold a portfolio of about 20-30 positions precisely because we know that some names will not perform well and that holding about that many stocks significantly diversifies our risks. Surprises can be positive, too, by the way – we miss opportunities as well as dangers. Ideally, the poor performance of stocks that do not reach their original intrinsic values either at all or within the time we hoped will be compensated by stocks that do better than we had originally thought, for example DirectTV, which received a takeover bid shortly after we bought it in January of this year.


While our four lines of defense will never prevent temporary drops in stock prices, they will hopefully go some way to dampening them, and they do go a long way to reducing the risk of permanent losses of capital.


Next month we will take a look at three other risks: the risk of a political and similar macro shock, the risk of getting the timing of purchases and sales wrong and the risk that the performance of the fund company itself is impaired.


--Georg von Wys