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Managing the risk of being wrong

26 July 2016 Nick Curtin, Foord Asset Management
Nick Curtin, Investor Relationship Manager at Foord Asset Management.

Nick Curtin, Investor Relationship Manager at Foord Asset Management.

Investment risk is defined as the risk of permanent loss of capital.

According to Nick Curtin, Investor Relationship Manager at Foord Asset Management, the most undesirable outcome for any investor must be loss from which there is no prospect of recovery. Curtin adds that the investment landscape is full of examples: corporate bankruptcies, bond defaults, rights issues needed to recapitalise failing businesses, dilution from share options, corporate governance failures leading to share suspension or delisting, accounting failures grossly overstating reported earnings numbers, Ponzi schemes and other frauds and many more.

“Accordingly, investment risk must therefore be defined as the risk of permanent loss of capital.”

“This consideration of investment risk is critical when looking at portfolio performance relative to a market index or benchmark,” says Curtin. “While the approach is understandable, the analysis is one dimensional: Almost all widely used market indices are compiled using a free-float market capitalisation weighting methodology. This means that companies with very large market caps will have large weights in the market index. The construction of such indices considers only a company’s size and not the risk of permanent loss associated with an investment in that company.”

What is the role of risk management in building investment portfolios?

“At Foord we constantly ask the question: What if we are wrong in our investment thesis? Our long-term record of investment success shows that by successfully managing the risk of being wrong, we mitigate the risk of permanent capital loss. As a result, it has been possible over longer time periods to generate returns that are significantly in excess of a market index constructed without reference to investment risk,” says Curtin.

It is a truism that not every investment idea will pan out exactly as expected — unforeseen situations can arise that fundamentally change a company’s prospects and/or valuation. In addition, the fund manager often gets their investment thesis wrong for any number of reasons.

Curtin advises that there are two principal ways that Foord manages the risk of being wrong:

“The primary mechanism is through diversification, which is the process of including different investments in a portfolio with negative correlations to offset or minimise investment risks. For example, an unexpectedly sudden rise in interest rates would be negative for retail companies but would benefit the banking sector in the short term as a result of the endowment effect. There are many other examples covering variables such as inflation, exchange rates, commodity prices, investor sentiment, economic activity, and the interplay or correlation of such factors with each other. By making sure there are enough diverse drivers of return in the portfolio, we are able to ensure a reasonable outcome, even in those instances when our base investment case turns out to be wrong.”

“The second key aspect to managing the risk of being wrong is a constituent of diversification, namely position size,” says Curtin. “Clearly, the potential impact on the total portfolio resulting from a single investment going wrong is directly proportional to the relative size of that investment in the total portfolio. So it stands to reason that we must be extremely vigilant about letting any single position get too big in the portfolio if we are to manage the risk of permanent loss. That said, the more conviction we have in an investment idea, the less diversification we need, which allows us to tolerate fewer stocks of larger position size in the portfolio. Indeed, holding too many stocks in a portfolio has been referred to as ‘diworsification’.”

Elroy Dimson, a professor at the London Business School, said, ‘Risk means more things can happen than will happen’. “Just because a risk does not eventuate does not mean it was not there and should not have been considered and mitigated,” warns Curtin. “While we cannot control the outcome of events, we can arrange our affairs in such a way that we survive intact should the worst transpire. The typical twin-engine airliner can still take off, fly and land if one engine fails — that is an example of very practical risk management.”

And this is where the index comparison starts to get interesting and why there is a very good reason that Foord does not use the market index as a starting point when building portfolios: “Because the index is dominated simply by whatever is big, it pays absolutely no attention to the concept of investment risk,” advises Curtin. “Currently, about 25% of the FTSE/JSE All Share Index is comprised of just two companies: Naspers (13.1%) and SABMiller (11.8%). When you add CF Richemont (5.9%), you see that nearly one third of the market index comprises only three companies.”

“Having 13% of a portfolio in any one investment is, in Foord’s opinion, imprudent. If holding nearly a third of the portfolio in only three businesses results in a ‘market neutral’ position, then the index construction is sub-optimal. This does not mean we are casting aspersions on the investment prospects of Naspers, SABMiller or Richemont (Foord portfolios are invested in all three businesses and have been for some time). Rather, we hold these shares in proportion to our assessment of fundamental investment risk — position sizes that are significantly lower than those in the market index (see table). The converse is also true: There are a number of holdings in Foord portfolios where position size is significantly larger than that of their index weight simply because they are small, but attractive, businesses.”

Curtin concludes that while most investors are single-mindedly obsessed with performance relative to the index, this is in truth a one-dimensional assessment. “When comparing the portfolio to the index portfolio from an investment risk perspective, it is like comparing apples and pears. However, Foord’s track record of out-performance shows that, in the long term, the application of sound judgment to portfolio weights while ignoring the index weights results in significantly better performance with lower risk of loss.”

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