Ariel Investments Portfolio Manager Rupal Bhansali answered questions about risk. Rupal is the Portfolio Manager for the following Global Strategies: Ariel International Fund, Ariel Global Fund, Ariel International (DM), Ariel International (DM/EM), Ariel Global, and Ariel Global Concentrated. Read the full Q&A below.
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.
Question: How do you define risk? How do you think about risk?
Answer: 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.
Question: What are, in your opinion, the most important factors to consider when evaluating risk?
Answer: 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.
Question: Is there a way to measure risk? What types of risk metrics do you employ?
Answer: 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.
Question: At what point is risk a consideration in the valuation process?
Answer: 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
Question: Do the moat ratings or debt ratings factor in your risk analysis?
Answer: We do not employ proprietary moat or debt ratings, but we consider competitive advantages and financial leverage as part of our fundamental analysis.
Question: What does a margin of safety mean to you? How does a margin of safety mitigate risk in the portfolio?
Answer: 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.
Question: How does the “Devil’s Advocate” analyst fit in your evaluation of company risk?
Answer: 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.
Question: Do you have an ongoing risk monitoring process once an investment is selected for the portfolio?
Answer: 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.
*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.