Ariel Investments Portfolio Manager David Maley answered questions about risk. David is the Portfolio Manager for the following Deep Value Strategies: Ariel Discovery Fund, Ariel Micro-Cap Value and Ariel Small Cap Deep Value. Read the full Q&A below.
Investing in small- and micro-cap stocks is more risky and volatile than investing in large-cap stocks. The intrinsic value of the stocks in which Ariel Discovery Fund invests may never be recognized by the broader market.
Question: How do you define risk?
Answer: I define risk as the possibility of permanent impairment of capital.
Question: How do you think about risk?
Answer: : The Ariel Discovery Fund seeks to find investment opportunities with a potentially sizable margin of safety*, which we define as the difference between the intrinsic value of a stock and the market’s current price.
Question: What are, in your opinion, the most important factors to consider when evaluating risk?
Answer: We believe that certainty of underlying asset value is the most important factor to consider when evaluating risk. In addition, management can make a decision that leads to permanent impairment of capital. Thus we focus on identifying companies with strong, properly incentivized leadership.
Question: Is there a way to measure risk? What types of risk metrics do you employ?
Answer: It is difficult to measure risk or quantify risk in our world. The factors that impact risk are the value of the underlying assets and the decisions made by management that could impact asset value. We focus on understanding those factors, rather than honing in on one specific metric.
Question: At what point is risk a consideration in the value process?
Answer: We are constantly considering the risk of any given investment. We pay particularly close attention to risk when deciding to initiate a position and after management has made a decision that could impact the underlying asset value of a company.
Question: Do the moat ratings or debt ratings factor in your risk analysis?
Answer: The companies that we own typically do not have meaningful debt and they tend to have excess cash. Moat ratings are rarely applicable in small and micro-cap asset-based investments.
Question: What does a margin of safety mean to you? How does a margin of safety mitigate risk in the portfolio?
Answer: It means investing where we can be wrong about a company, but right as investors.
Question: How does the “Devil’s Advocate” analyst fit in your evaluation of company risk?
Answer: The Deep Value team participates in weekly meetings, and although we do not have a formal “devil’s advocate,” at these meetings, analysts and portfolio managers discuss, debate, and defend investments. We have cultivated an environment that encourages communication and risk monitoring.
Question: Do you have an ongoing risk monitoring process once an investment is selected for the portfolio?
Answer: We are constantly monitoring the risks of each individual investment. It is a dynamic process that impacts portfolio construction. We determine position size based on our estimate of the discount to fair value and our conviction levels. If the discount to fair value changes, we will adjust the position size accordingly.
*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.
by David Maley: