Ariel Investments Portfolio Manager Tim Fidler answered questions about risk. Tim is the Co-Portfolio Manager for the following Value Strategies: Ariel Appreciation Fund and Ariel Mid Cap Value. Read the full Q&A below.
Investing in 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 Appreciation Fund invests may never be recognized by the broader market.
Question: How do you define risk?
Answer: Broadly speaking, we define risk as the potential for permanent impairment of capital.
Question: How do you think about risk?
Answer: 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.
Question: What are, in your opinion, the most important factors to consider when evaluating risk?
Answer: 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.
Question: Is there a way to measure risk? What types of risk metrics do you employ? Do the moat ratings or debt ratings factor in your risk analysis?
Answer: 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.
Question: At what point is risk a consideration in the valuation process?
Answer: We believe that risk is a consideration at every point in the valuation process from initial due diligence to ongoing maintenance coverage.
Question: What does a margin of safety mean to you? How does a margin of safety mitigate risk in the portfolio?
Answer: 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.
Question: How does the “Devil’s Advocate” analyst fit in your evaluation of company risk?
Answer: 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.
Question: Do you have an ongoing risk monitoring process once an investment is selected for the portfolio?
Answer: 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.
*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.
+Attempting to purchase with a margin of safety on price cannot protect investors from the volatility associated with stocks, incorrect assumptions or estimations on our part, declining fundamentals or external forces.
by Tim Fidler: