The Role of Risk

Of all the evils the investor must face, the devil of risk is perhaps the most treacherous. For most investors, risk simply means losing money. But the gospel according to the academics who constructed the intellectual edifice of how to invest – the Efficient Market Hypothesis (EMH) and Modern Portfolio Theory (MPT) — is quite different. To them, since every investor is rational and hence risk-averse, they are willing to take on greater risk for higher pay-offs and will accept lower returns if they assume less risk. This wonderfully elegant but flawed premise has led to the way we measure risk. MPT is based on the notion that risk is equal to price volatility, or, put differently, the extent to which share prices fluctuate determines their riskiness.

Unfortunately, while this definition is useful in building complex mathematical models which intimidate the non-believers, it fails to address a number of empirical observations. First, even the academics accept that there is no proven correlation between volatility and returns using historic stock price data for any given period. Second, in the mind of the investor there is a huge difference between volatility on the upside and downside! I have yet to meet an individual who is discomforted by his stocks outperforming the index in a bull market. Third, and perhaps most troubling for the architects of MPT, is that measures of volatility fail to remain constant over time.

For volatility to be a useful measure of risk, it must have predictive power. If volatility in one period has little or no correlation with that in the next, then MPT falls flat on its face since the mantra of risk reduction through asset allocation breaks down! In effect, investors care about the risk from an uncertain future, the risk that things will turn out to be worse than we expect. The rear-view mirror approach of volatility is entirely worthless in dealing with such concerns. Why volatility? One obvious reason is that volatility, misplaced as it is, can be measured whereas uncertainty cannot be quantitatively addressed.

Warren Buffett once remarked that risk is tantamount to not knowing what you are doing. This idea provides a far superior framework in helping to cope with the real threats that imperil investors. Understanding the nature of the business and its ability to flourish in a competitive environment is the cornerstone of sensible risk assessment. Obviously a number of factors such as the ability of the management to control costs and allocate resources efficiently, the extent of financial leverage, the capital requirements for sustainable growth, the impact of change on competitive standing of the business, all matter. But most important is determining the right price to pay for the business compared to your estimate of its intrinsic worth to ensure that there is an adequate margin of safety which allows you to deal with the mood swings of Mr. Market and the inadequacies of your own judgment!

This approach actually suggests that volatility may be a source of great opportunity rather than risk. Simply put, when the price of a high quality business declines more than the comparable market index, the volatility increases but so does the margin of safety. Ben Graham captured the essence of this concept when he wrote, “the chief losses to investors come from the purchase of low-quality securities at times of favourable business conditions. The purchasers assume that prosperity is synonymous with safety.”

Where does the compass point in the heady markets of today? TIL Ltd (Rs. 528) seems to be pointing due North. This Kolkata-based company which distributes Caterpillar products and manufactures cranes is well positioned to benefit from a surge in capital spending. The company has a pristine balance sheet, a consistent track record of predictable and growing cash flows and competent management which values its reputation for integrity. With reasonable growth prospects, a trailing PE of 8 and ROCE (return on capital employed) in excess of 30 percent clearly the risks of a negative surprise appear minimal. As the French philosopher Henri Poincare noted: “We all know how cruel the truth often is, and we wonder whether delusion is more consoling.”  

Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author, a partner at Fortuna Capital, frequently invests in the shares discussed by him.