Investing in micro-, 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. Investments in foreign securities may underperform and may be more volatile than comparable U.S. stocks because of the risks involving foreign economies and markets, foreign political systems, foreign regulatory standards, foreign currencies and taxes. The use of currency derivatives and exchange-traded funds (ETFs) may increase investment losses and expenses and create more volatility. Investments in emerging and developing markets present additional risks, such as difficulties in selling on a timely basis and at an acceptable price. The intrinsic value of the stocks in which the Funds invest may never be recognized by the broader market. Ariel Focus Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment.
How do you define risk? How do you think about risk?
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.
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.
We think of risk as permanent loss of capital, not short term price fluctuation which merely represents volatility. We think risk management is very important in achieving return management. Differently put, capital preservation is instrumental in capital appreciation. This is because preserving capital in big down markets can allow for appreciation to begin earlier than if higher losses had to be recouped.
Broadly speaking, we define risk as the potential for permanent impairment of capital.
Our fundamental belief is that stock prices are more volatile than the true underlying values of the business that they represent. Thus, stock price volatility, while uncomfortable, is not a primary risk to a long term investor. In the long-run, we believe stock prices should converge to the true underlying value of the business. This is the central mechanism by which patient investors can be rewarded for taking advantage of the market’s mood-swings and use volatility to their advantage.
I define risk as the possibility of permanent impairment of capital.
The deep value strategies seek 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.
What are, in your opinion, the most important factors to consider when evaluating risk?
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.
Both qualitative and quantitative factors should be considered when evaluating risk.
Our qualitative risk assessment considers whether a company’s business model and strategy will stand the test of time, competitive threats, corporate governance matters, and capital allocation priorities. Quantitative risk factors incorporate an assessment of a company’s returns relative to its risk profile, balance sheet strength, and trading liquidity, among other factors.
Beyond the bottom-up risk assessment, we consider various additional risk factors as we aim to optimize portfolio-level risk, such as ensuring appropriate diversification across stocks, sectors, and regions.
We focus on evaluating the strength of a business’s franchise. We perceive stable, high quality businesses as exhibiting lower risk, thus our research effort evaluates every company’s competitive advantages and points of differentiation. Additionally, balance sheet strength can serve to lower risk as financial distress can harm even the most competitively advantaged businesses.
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.
Is there a way to measure risk? What types of risk metrics do you employ?
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.
I consider risk to be a permanent loss of capital in the long run. In my view, there are no specific risk metrics other than measuring how capital grows or shrinks over a full market cycle. It is worth adding that we do not view beta or tracking error as measures of risk and do not manage our portfolio to such metrics.
Every company and potential investment opportunity is assigned an economic moat as well as a proprietary debt rating. The economic moat rating* is determined through a thorough analysis of a business’s profitability and return profile, growth characteristics, and competitive positioning. Our debt ratings utilize fixed income market data such as bond-implied gaps and credit default swap spreads as well as traditional credit analysis to arrive at a debt rating that we feel is more accurate and timely than conventional debt ratings.
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.
At what point is risk a consideration in the value process?
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?”
We embed risk management throughout our investment process, from screening out high risk businesses to self-imposing risk controls in the portfolio construction stage.
In our valuation work to estimate intrinsic values, we stress test each company from a bottom-up perspective using various scenarios to assess potential threats including business model impairment, industry drivers, balance sheet strain, competitive challenges, macroeconomic resilience, and political and regulatory considerations, among others. This process allows us to preemptively identify and attempt to quantify worst-case scenarios so the portfolio manager is armed with this information to better withstand periods of stress. While our portfolio construction is primarily driven by stock selection, as part of our 360-degree fundamental due diligence and risk management, we pay attention to all risk factors – bottom-up and top-down – that affect our analyses.
Notwithstanding the above, the goal of our risk management efforts is not eliminate all risk, but to be paid to take it. Despite our best efforts, we can’t identify or correctly quantify all risks. An investor should be prepared for some loss of capital in the short run as investment mistakes can and do occur. This is why a patient approach to investing in equities as an asset class is a prerequisite to long term investment success.
We believe that risk is a consideration at every point in the valuation process from initial due diligence to ongoing maintenance coverage.
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.
Do the moat ratings or debt ratings factor in your risk analysis?
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.
We do not employ proprietary moat or debt ratings, but we consider competitive advantages and financial leverage as part of our fundamental analysis.
Every company and potential investment opportunity is assigned an economic moat as well as a proprietary debt rating. The economic moat rating+ is determined through a thorough analysis of a business’s profitability and return profile, growth characteristics, and competitive positioning. Our debt ratings utilize fixed income market data such as bond-implied gaps and credit default swap spreads as well as traditional credit analysis to arrive at a debt rating that we feel is more accurate and timely than conventional debt ratings.
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.
What does a margin of safety mean to you? How does a margin of safety mitigate risk in the portfolio?
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.”*
Seeking a margin of safety* is a key underpinning of our intrinsic value oriented investment philosophy. To us, a margin of safety means taking measures in our fundamental and valuation analyses with the aim of avoiding a substantial or permanent loss of capital, even if an investment experiences temporary setbacks or headwinds.
A lesser permanent loss of capital can result in a portfolio that has greater scope to appreciate. This is how incorporating a margin of safety helps mitigate risk in the portfolio.
Our private market values, or estimates of the company’s intrinsic value, serve as de facto price targets. It is our assessment of what the company is worth when performing at a normalized level. Conversely, a margin of safety* is a reduced value of the company and its assets in a downside scenario. We utilize the concept of a margin of safety to attempt to mitigate downside risk in the portfolio by reducing our assessment of a company’s future prospects.
It means investing where we can be wrong about a company, but right as investors.
How does the “Devil’s Advocate” analyst fit in your evaluation of company risk?
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.
Each investment debate on a stock comprises three members of the investment team: a lead analyst who champions the idea, a “devil’s advocate” who offers pushback and feedback, and a fresh analyst who can bring a different perspective to the topic at hand. This ensures a more balanced understanding of the investment’s pros and cons, before an idea gets into the portfolio.
The “devil’s advocate” process ensures that our investment thesis remains up-to-date and fully vetted through an objective, skeptical lens. The devil’s advocate works with the primary analyst throughout the investment process to highlight any risk that may be overlooked or deemphasized and clearly articulates the contra-case to our investment thesis.
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.
Do you have an ongoing risk monitoring process once an investment is selected for the portfolio?
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.
Yes. We continually monitor all investment holdings for their risk exposures. At the portfolio level, we monitor risk periodically, but no less than quarterly to evaluate and stress test the impact of various macro risk factors such as a sovereign crisis.
All of our proprietary risk metrics are maintained in concert with the more basic building blocks of the research process such as private market value (“PMV”) and earnings per share (“EPS”) estimates. They are evaluated and monitored on a continued basis and included in all of our real-time portfolio analytical tools.
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.
+An economic moat is a perceived competitive advantage that acts as a barrier to entry for other companies in the same industry. This perceived advantage cannot protect investors from the volatility associated with stocks, incorrect assumptions or estimations, declining fundamentals or external forces.