Ariel Investments Portfolio Manager Charlie Bobrinskoy answered questions about risk. Charlie is the Portfolio Manager for the following Value Strategies: Ariel Focus Fund and Ariel Focused Value. Read the full Q&A below.
Ariel Focus Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment. Investing in small- and mid-cap stocks is more risky and volatile than investing in large-cap stocks. Investing in equity stocks is risky and subject to the volatility of the markets. The intrinsic value of the stocks in which Ariel Focus Fund invests may never be recognized by the broader market. Past performance does not guarantee future results.
Question: How do you define risk?
Answer: : It is critical to understand the importance of three definitions of risk: 1) How the market is currently defining risk (and therefore what risks the market is demanding compensation in the form of higher expected returns for taking) 2) How I personally as an investor define risk (and therefore the risks that I personally demand compensation for taking) and, 3) Very importantly, how my clients define risk. The key is to get alignment between 2 and 3, and then take advantage of differences between 2/3 and 1. Today, the market is clearly defining risk as the possibility of underperforming more than the market in a down market, even on a relatively short term basis. This is sometimes called “downside capture” and is measured over periods as short as a month. I personally define risk as the loss of permanent capital over a medium term, say five years. In other words, risk is the chance that I will make an investment and, after approximately five years, have less economic purchasing power than I started with.
Question: How do you think about risk?
Answer: I believe in the critical finding of Modern Portfolio Theory; namely, risk must be measured in terms of all of one’s investments, not a single investment made out of context.
Question: What are, in your opinion, the most important factors to consider when evaluating risk?
Answer: The most important factors to consider are the risks the markets are overly focused on and the risks the markets are ignoring. Today, the market is extremely focused on the risk of a recession or a short term downturn in the stock market. The market is NOT focused on the risk of inflation or a significant increase in interest rates.
Question: Is there a way to measure risk? What types of risk metrics do you employ?
Answer: Most measures of risk are backward looking. Stocks are deemed risky if they underperformed in past down markets. The challenge in measuring risk is that it is, by definition, a prediction about the future and therefore resistant to precise measurement. The temptation is to measure risk by the frequency of events in the past. But, to paraphrase Warren Buffett, “If the future looked exactly like the past, librarians would all be millionaires.”
In some fields, risk can indeed be accurately predicted from the past. Historical car accident rates are indeed a pretty good predictor of the risk of future car accidents. But, as we learned in 2008, historical mortgage default rates may not be good predictors of future mortgage default rates. In equity investing, a key goal is to make predictions about how future performance will vary from past performance.
Question: At what point is risk a consideration in the value process?
Answer: Properly employed, risk should always be a consideration in the value process. It is a critical component in determining a company’s intrinsic value, as we use a higher discount rate in discounting future cash flows of riskier companies. Value investing is always about trading off risk and expected return. A value investor is always asking himself/herself, “Am I being adequately compensated for the risk I am taking?”
Question: Do the moat ratings or debt ratings factor in your risk analysis?
Answer: Moat ratings and debt ratings are critical components in our analysis of risk. Ultimately, the debt rating is designed to incorporate all sources of risk for a company, and is then translated into a corresponding discount rate. The lower the debt rating, the higher the perceived risk, and the greater the required future cashflow to compensate us for that risk. Two companies may have identical projected cashflows; but if one has a lower debt rating (and therefore higher perceived risk), we will calculate a lower intrinsic value and require a lower stock price before purchasing. Moat ratings are designed to help us monitor business risk. A company with a declining moat has a higher probability of lower returns on capital in the future and should, therefore, have lower projected cashflows going forward, all else equal.
Question: What does a margin of safety mean to you? How does a margin of safety mitigate risk in the portfolio?
Answer: A margin of safety is a cushion for error. It is based on the realization that most calculations end up being too optimistic. Most companies do not meet previous estimates of profitability. Therefore, margin of safety is a concept value investors impose on themselves to say, “even if I am wrong and things turn out worse than I expect, I will still hopefully make a reasonable return on my investment if I purchase at or below this price, which is well below my calculation of intrinsic value.”*
Question: How does the “Devil’s Advocate” analyst fit in your evaluation of company risk?
Answer: The Devil’s Advocate is Ariel’s formal answer to the problems of Confirmation Bias and Optimism Bias. All human beings have a natural tendency to seek out evidence which is supportive of our previously held opinions. If you are a Republican you will tend to watch TV stations which are optimistic about the political prospects of conservative candidates. Likewise, if you are bullish on the outlook for automotive stocks, you will tend to gravitate toward the research reports of analysts who are likewise bullish on the industry. The Devil’s Advocate is expressly charged with making the “bear case” on both current holdings and prospective investments. The Devil’s Advocate’s role is to ensure bearish arguments, analysis and news events get just as much attention as the more bullish variety.
Question: Do you have an ongoing risk monitoring process once an investment is selected for the portfolio?
Answer: I monitor risk at both the individual stock and portfolio level. I am consistently monitoring factors which affect risk such as debt levels, moat ratings and sell side sentiment, as well as measures of optimism/pessimism such as forward PE multiples.
*Attempting to purchase within a margin of safety on price cannot protect investors from the volatility associated with stocks, incorrect assumptions or estimates on our part, declining fundamentals, nor external forces.