- Our views on risk

Investment
Process



For Investors, Risk and Error are Constant Companions

(These comments reveal how we regard, and deal with, risk.)

There is no risk so great as the unwillingness to take any risk.

There is great risk in not understanding the various aspects of risk.

Risk is much mitigated through surveillance, attention and understanding.
 

The first order of importance is that of protecting and supporting the objectives of the investment entity itself, the needs of which guide and impose on all decisions as first priority.  After this is assured by a conservative selection of securities, it is both theoretically and practically appropriate to take risk where risk-taking pays off best.  In this way, relatively high overall rates of returns can be realized while relatively small amounts of assets are deployed at significant risk.

Risk is commonly measured as volatility at business schools and by practitioners of modern portfolio theory.  Volatility (fluctuation in prices of marketable securities) is an easily captured numerical expression of historical price behavior. The measurement’s usefulness is limited in that it provides little or nothing more.

Rapid gains from a “norm”, as well as rapid downward departures, are both considered to be volatility.  If all stocks have behaved exceptionally well (or poorly), one’s asset mix will be classified with a high quotient of volatility, or “risk” by this definition.

Some Basic Defining Parameters and Characteristics of Risk:

Risk is attenuated by diversification; however, diversification also increases exposureto risk. Thus, one loses while gaining.

Risk is intensified by commercial competition, and reduced by lack thereof.

Risk is reduced by competence of enterprise management, or increased by lack thereof.

Risk is decreased by product (or service) usefulness and uniqueness, and the pricing freedoms accorded therefrom.

Risk is related to opportunity, which, according to the scale and the probability of its realization, mitigates or enlarges risk.

Risk is inversely Related to understanding and attentiveness.

Stock Price (as reflected in market capitalization) is the real world’s approximate equator of risk. In refinement and in common use, price (as an expression of expected returns) is related to the riskless return from high-grade, short-term credits.  Risk rises directly with price and falls directly with price (unless one is trading instead of investing).  At extremely low prices, nearly everything is riskless; at extremely high prices, nearly everything is risky.

The Following Commonly Applies.

For common stocks, risk analysis is largely a short-term appraisal.  In fully-grown, liquidity-sponsored markets (such as in the U.S.), volatilities lead to shortened holding periods through more frequent sales and purchases.  Though purchasing might be predicated upon long-term growth, the attractiveness of such growth can be quickly negated by an advance in share prices.  The risk relative to prospective reward voids justification for its ownership.

For bonds, which are long-term contracts, risk appraisals require intensive analysis of industries, enterprises and legal provisions of the issuance.  (The devil is quite commonly in the details.) Assumptions (or hypotheses) are projected over the life of the long-term contract.  For bonds, the best one can do is to have the contract fulfilled - anything less is unacceptable. A worst-case is the essential test for bond analysis.  On the other hand, a worst-case analysis for share purchase is likely to scare off virtually all buying, to the detriment of eventual investment results. A reasonable best case is the beginning point of common share analysis. 

Bonds are used as the preferred instruments to minimize risk and to supply needed income. The avoidance of (1) poor credits, and (2) overvalued shares (now most of the popularly owned shares) is also a first line of risk minimization.

The purchase of shares at attractive valuations is the common denominator of our share selection. We diversify into a number of focused, you-can-get-your-arms-around-it opportunities. A scatter of these (having little commonality of product and services) seems the better diversification than the conventional diversification by industry.  The long years of bull markets have narrowed the differential between defensive and growth stocks, so that industry rotation, by and-large, has lost the advantages it had from the 1950’s through the forepart of the 1980’s. LBO’s, mergers and acquisitions among companies, and an abundance of liquidity also contributed to this narrowing of spreads.  This is by way of saying that a larger percentage of shares of well-known,established companies are subject similarly to risks of general market price influences.

Princeton Capital Management does not present its portfolio according to commonly used categories, unless clients request it be presented in such a fashion.  For unlike reasons, we think distinguishing between domestic and foreign shares has lost most of its meaning, as far as the principal nations of the world are concerned. Most major enterprises source internationally and market internationally, and it makes little difference whether their headquarters are along the Ohio River or along the Rhine River, or reside somewhere else in the world within a well-ordered society.  Taking political risk is quite a different matter (something we do not consider doing) as opposed to taking currency risk, which is often neutralized by international sourcing and international marketing or by risk management.

Volatility of share prices of rapidly growing enterprises is an acceptable risk for long-term investors (after liquidity needs are satisfied, of course). Relative volatility expresses risk in only very partial terms, which says too little about enterprise risk to be very useful, and says nothing about how rapidly a young, vigorous enterprise is outgrowing relative hyper-volatility.

Within the limits of the tolerance and disposition of a client, selections toward both ends of the risk spectrum — defined as extending from high quality bonds to the shares of young, and still tender, enterprises — generally give greater returns for total risk incurred than that obtainable from a mix drawn from the center of the stock market. Well-known companies commonly are overpriced after long periods of bull markets, delivering to the owners a substantial degree of market risk. Thus, investors would be unduly exposed to sharp downside price adjustments or to stagnation for years.

Weighting a portfolio at both ends of the risk spectrum is sometimes referred to as creating a “dumbbell balance”. The dumbbell assists the weightlifter in balancing with the advantage of mechanical leverage.  In the event the sheer weight (of the market) becomes overwhelming, there is protection in having weights at the extreme ends of risk, just as there is for a weightlifter in the event he falls.  For investors as well as for weightlifters, the dumbbell is a very economic use of form and weight.  In contrast, if one owns only center-of-the-market shares, there is little or no avoidance of the consequences of a market drop.

By and large, the center of the market returns good results only in bull market phases (no longer to be counted on). The overlooked corners of the market and undervalued rapidly growing young companies often, as now, give attractive reward/risk ratios after such a long bull market phase. 

It must be acknowledged that an uncommon selection of shares might be directly associated with volatility, for, if shares are uncommonly recognized, their market liquidity will be circumscribed thereby.  However, uncommon selections do not necessarily entail most other forms of risk. The lack of familiarity is more likely to lead to attractive pricing, and less fundamental risk to the long-term investor.

Take comfort in owning shares that few people know about.  As these shares come into broader recognition, the price will likely improve, giving the first stage of gain.  If the selection were right in the first place, there will also be the pull of earnings as a gain. That combination is likely to eventuate in an excessive valuation, especially if a market is supported with a wealth of liquidity.  Selling early and rejuvenating the portfolio mix by purchasing companies that are still unrecognized is one of the best means of controlling risk and enlarging rates of return.

 

  47 Hulfish Street (at Palmer Square), Princeton, New Jersey 08542
Telephone: (609) 924-6867 • Fax: (609) 921-9502 • E-mail: [email protected]