Risk is a vital part of thinking about investing, even though you can’t put a number to it. You can’t really start applying many of the ideas in this book without having a good grounding in what makes a risky investment and what makes one investment more or less risky than another.
I think of the concept of risk in terms of enterprise value, cash flows, and asset values. Those three important concepts again. Most investors think about risk in terms of price. They buy a stock, and risk means the probability that the stock price will go down.
By this point, I hope you see that this is not a good conception of risk. You understand now that stock prices are judgments of value that you should not rely on. The public market quotations are going to change in ways that seem irrational. You need something else in which to anchor your concept of risk—and that’s your understanding of enterprise value, cash flows, and asset values.
So how should you think about risk?
First, you should understand that risk is more useful with an adjective in front of it — that is, as a specific kind of risk. For example, there are market risks and there are business risks. A market risk is the risk of the stock price moving against you in the short term. We don’t worry about this risk, which is the risk of unrealized losses or a reduction in unrealized profits. Market risk is a risk you should ignore.
What we are most interested in is the business risk — a specific risk to the particular business we are looking at. It might be the risk of a big customer leaving or the risk of losing a key contract. It might be the risk of a costly development project not panning out. Business risks can be lots of specific things. What we don’t want is a lot of risk that something bad will happen to the business itself.
The great risk we try very hard to avoid is the risk of permanent capital impairment. This is a fancy phrase that captures the idea of a business losing a material amount of money, suffering a severe drop in asset prices, or losing its credit standing. Basically, it is a real material loss that affects what the business can achieve in the long run. Permanent capital impairment shrinks the possibilities of what a business can achieve.
For example, suffering heavy losses that put the company in bankruptcy is an example of severe permanent capital impairment. Much will be lost to creditors — if not everything — and the stockholders’ interest in the company will be permanently impaired or lessened.
A less severe impairment may be technological obsolescence that has caused a significant piece of the company’s business to be worth much less than what was thought. Technology companies usually carry a good amount of this kind of risk that can have you waking up one day to find a competitor has passed you by or an industry has died. If you made typewriters, your business suffered a permanent impairment with the widespread adoption of the computer.
In mining, a permanent capital impairment may be the exhaustion of an important mine; a business in another industry may suffer the loss of a key asset when it is confiscated by a foreign government.
Corporate corruption can lead to permanent impairments. Fraudulent accounting, which leads to a huge write – down of assets, is permanent capital impairment.
We aim to avoid these risks as best we can. One easy way, as I’ve already pointed out, is to stick with companies with strong balance sheets and little debt. Without getting too much into accounting details, a strong balance sheet is one in which there is little debt, good liquidity (that is, some idle cash), and not a lot of funny assets — like goodwill (which we strip out in our analysis anyway).
As an aside, you should realize that your goal as an investor should not be to eliminate risk entirely. Every investment brings an element of risk. There is always something that can go wrong.
Even for insiders. There is a common misperception that insiders somehow have a free ride. The thinking is that their information is so good that they can’t go wrong. Hence, a number of services have grown up around the idea of following insiders. This can be a very good way to look for potential investments. However, you should realize that insiders face risk when they invest in stocks.
As an outsider, your risk is probably greater, but not always. I have seen insiders who believe so much in their own story that they are the last people to find out when it is no longer valid. They are like the proverbial captains who go down with their ship.
The main way I limit risk, both in what I recommend in Capital & Crisis and in my own investing, is to focus on the downside in my analysis. What we could make means nothing without having a sense of what we could lose and of the probability of experiencing such a loss. I’ m reminded a bit of a Charles Bukowski poem about one of his many visits to the local racetrack. He’s sitting there, drinking his beer and watching the horses but not betting. Finally, someone comes up to him and says: “You come here to win, don’t you? ”
Bukowski’s reply was: “I come here not to lose. ”In the same way, my focus in the stock market is on not losing. And the best way to do that is to pay a great deal of attention to the price I pay for an investment. In fact, I believe this kind of discipline is the most important part of any investment program. Here is an example of an investor who did a great job in covering his downside.
