As value investors, risk management is at the core of our investment process.
Academics and much of the finance industry use a security’s volatility as the primary measure of risk, but value investors will often take a slightly different approach. In a 2014 memo Howard Marks of Oaktree Capital posits that this acceptance of volatility as risk is so widespread simply because volatility is quantifiable and easily measured. Although it is easy to observe, we believe that using volatility as a measure of risk inherently presents a few problems for long-term oriented investors.
First, volatility and the increase or decrease in the true value of a security are not necessarily correlated. The volatility of a security can often fluctuate much more than the fundamentals of the underlying business. Additionally, most investors are only concerned with downside volatility and would not equate upside volatility to increased risk. However, many market participants do not discriminate between upside and downside volatility, meaning that a stock that frequently gaps up in price will be considered just as risky as one that frequently gaps down.
Benjamin Graham, widely considered as the Father of value investing, once said, “In the short run the market is a voting machine, but in the long run it is a weighing machine.” Essentially, price fluctuations in the short-term are a result of sentiment and investor psychology, whereas fundamentals and business performance matter most in the long-term. As long-term investors who are focused on fundamentals rather than day to day market sentiment, we prefer to define risk as the chance of permanent capital loss. We understand that our investment success is much more dependent on the performance of the underlying business than on short-term sentiment and price movements.
At Altron Capital Management we use Benjamin Graham’s margin of safety principle as a framework for managing risk in our client portfolios. This involves analyzing a particular security, estimating its intrinsic value based on our understanding of both the qualitative and quantitative aspects of a business, and waiting for an opportunity to buy that specific security at a significant discount to our estimate of intrinsic value. The discount at which we buy compared to our estimate of intrinsic value is our margin of safety. The greater the margin of safety, or the lower price that we pay, the lower the chance of permanent capital loss. Conversely, paying higher prices correlates to taking on more risk and a higher chance of future losses.
By maintaining discipline about buying with a large margin of safety, we are afforded a buffer between the assumptions underlying our estimates of intrinsic value and the actual future outcomes that affect the future prices of the security. Thus, even if certain negative outcomes materialize, the intrinsic value of the business has some room to fall before we deem to have incurred a permanent capital loss.
When we are unable to acquire securities with a margin of safety, we are content with inaction and waiting patiently for the markets to present more attractive pricing, regardless of how much we like the underlying business. Our long-term approach and focus on a business’ intrinsic value allow us to be opportunistic and purchase securities with attractive risk-reward profiles when negativity and short-termism dominate the markets.
Contact us for more information about how we manage risk throughout our investment process.
