Risk management is the essence of a value investing approach. Creating a margin of safety at each stage is really nothing but a form of protection against errors of judgment and bad luck
My belief in behavioural economics and the importance of “fundamentals”, risk seems to be probably the most misunderstood concept in modern finance. Clearly, risk is not defined numerically by measuring the standard deviation of historic returns. Rather, it is a concept that helps an investor to focus on the factors that might lead to “a permanent loss of capital”.
The Dean of value investing, Benjamin Graham, identified three primary sources of danger: Valuation risk, business risk and balance sheet/financial risk.
The Dean of value investing, Benjamin Graham, identified three primary sources of danger: Valuation risk, business risk and balance sheet/financial risk.
Valuation risk- Most of us know that the stock-market performance of a company is driven more by changes in expectations rather than actual corporate results. This is further compounded by the basic math that determines investment results: If you suffer a 50 percent decline, you must double the current value to just get back to where you started out from.
The second source of danger — business risk — is really to assess the lasting damage that can be caused to earning power as a result of negative changes in the environment. Quite often we assume that current margins can be extrapolated indefinitely into the future rather than contemplate the prospect of mean reversion caused by cyclicality and a deterioration in the business outlook. Indian IT services companies find themselves at an important turn in the road — greater long-term strength for the rupee, an inability to move up the value chain, increasing competition as well as a more hostile political environment in the US. The habit of comparing current earning power to long-term averages can help you keep out of trouble — at least one will receive early warning signs of a “value trap”.
The final element of this unholy trinity is balance sheet risk. In essence, this translates into a compulsive focus on cash flow. Rising debtors or inventories, relentless capital expenditure leading to greater financial leverage or constant equity dilution, declining operating efficiency, an inability to improve or maintain productivity, eccentric capital allocation, all lead to fragile cash flows and deteriorating financial health.
Interestingly, investors are pre-occupied with “reported earnings” and growth at the height of booms, oblivious to the seeds of destruction being sowed for the long haul!The second source of danger — business risk — is really to assess the lasting damage that can be caused to earning power as a result of negative changes in the environment. Quite often we assume that current margins can be extrapolated indefinitely into the future rather than contemplate the prospect of mean reversion caused by cyclicality and a deterioration in the business outlook. Indian IT services companies find themselves at an important turn in the road — greater long-term strength for the rupee, an inability to move up the value chain, increasing competition as well as a more hostile political environment in the US. The habit of comparing current earning power to long-term averages can help you keep out of trouble — at least one will receive early warning signs of a “value trap”.
The final element of this unholy trinity is balance sheet risk. In essence, this translates into a compulsive focus on cash flow. Rising debtors or inventories, relentless capital expenditure leading to greater financial leverage or constant equity dilution, declining operating efficiency, an inability to improve or maintain productivity, eccentric capital allocation, all lead to fragile cash flows and deteriorating financial health.
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