Given my abiding belief in behavioural economics and the importance of “fundamentals”, risk seems to be probably the most misunderstood concept in modern finance. Clearly, risk is not defined numerically by measuring the standard deviation of historic returns. Rather, it is a concept that helps an investor to focus on the factors that might lead to “a permanent loss of capital”.
The doyen of value investing, Benjamin Graham, identified three primary sources of danger: Valuation risk, business risk and balance sheet/financial risk. Most of us know that the stock-market performance of a company is driven more by changes in expectations rather than actual corporate results. It is precisely this “expectations treadmill” reflected by valuation metrics that is the reason for most of our grief. The disappointment caused by expensive stocks with clay feet is cruel and creates the potential for lasting damage. This is further compounded by the basic math that determines investment results: If you suffer a 50 percent decline, you must double the current value to just get back to where you started out from! The case for treading gently at the present juncture given the level of valuation risk built into stock prices is fairly compelling. The market is trading at 15 times optimistic estimates of earnings for the financial year ending March 2012 — not a bargain by any stretch of the imagination.
The second source of danger — business risk — is really to assess the lasting damage that can be caused to earning power as a result of negative changes in the environment. Quite often we assume that current margins can be extrapolated indefinitely into the future rather than contemplate the prospect of mean reversion caused by cyclicality and a deterioration in the business outlook. Indian IT services companies find themselves at an important turn in the road — greater long-term strength for the rupee, an inability to move up the value chain, increasing competition as well as a more hostile political environment in the US. The habit of comparing current earning power to long-term averages can help you keep out of trouble — at least one will receive early warning signs of a “value trap”.
The final element of this unholy trinity is balance sheet risk. In essence, this translates into a compulsive focus on cash flow. Rising debtors or inventories, relentless capital expenditure leading to greater financial leverage or constant equity dilution, declining operating efficiency, an inability to improve or maintain productivity, eccentric capital allocation, all lead to fragile cash flows and deteriorating financial health. Interestingly, investors are pre-occupied with “reported earnings” and growth at the height of booms, oblivious to the seeds of destruction being sowed for the long haul!
Risk management is the essence of a value investing approach. Creating a margin of safety at each stage is really nothing but a form of protection against errors of judgment and bad luck! A stock that certainly makes the cut for the “long-term greedy” given this approach is Blue Star (Rs. 436). Quite apart from the exceptional operating efficiency, highly disciplined capital allocation, robust competitive standing and outstanding management team, Blue Star is a riveting play on rising infrastructure spending — be it airports, hotels, hospitals, construction, the creation of modern retailing et al.
While the company has had a difficult start to the current year, it is worth pointing out that the compounded 10 year total return including dividends has been in excess of 40 percent with remarkable consistency throughout the decade. Business risk and balance sheet risk are truly minimal for Blue Star. However, at 20 times current year earnings and a dividend yield of just under 2 percent, Blue Star is certainly exposed to meaningful valuation risk. I suspect the impeccable pedigree provides adequate comfort to take the plunge for those with a time horizon extending beyond three years.
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.