- Our views on risk
Investment
Process
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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.
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