How embedding risk management in our thematic investment process can help clients avoid permanent loss of capital
What comes to mind when you consider the risk of investing in companies? Often our minds leap to the fear of a market correction, the next economic recession or the possibility of an adverse event such as war, epidemic, or election outcome. Such risks are frequently magnified by media headlines and usually skewed to the probability of negative outcomes.
Within the fund management industry, investment risk is traditionally measured by statistics such as tracking error, active share, relative drawdown, beta or volatility. The vast majority of these measures are calculated by comparing a company or a portfolio to an index such as the MSCI All Countries World Index.
What is your risk?
Consideration of what might happen in the future and how a company’s stock price may respond has a degree of merit. More fundamentally though, we can consider two risks of investing in equities:
- At a single stock level, what is the risk of a permanent loss of capital? Or, put another way, how likely is it that the investment case is fundamentally flawed leading to a financial loss that is never recovered, or at least not within a reasonable period of time?
- At a fund level, what is the risk that your portfolio fails to meet your investment objectives? What is the risk that a portfolio produces a sub-optimal outcome by comparison to other investment opportunities and what would the impact of this be?
It is worth noting that the selection of an asset class and in turn an index against which to measure risk and return is an active decision. Furthermore, to generate a return sufficient to at least offset inflation over the long-term means accepting some risk.
How do we mitigate risk?
Managing risk is embedded in each of the three stages of our investment process. The first stage is to identify themes that are driving the fortunes of companies; these themes can have positive or negative implications. The second stage is stock selection, a fundamental and rigorous team process that embeds stewardship considerations to consider whether a company is an attractive long-term investment. The third stage is portfolio construction, where we build a portfolio of our preferred thematic stocks that provides adequate diversification whilst ensuring it is the stock selection that drives potential returns rather than factors such as style or geographic bias. Investment performance is the outcome of this investment process and is not an input.
Avoiding a permanent loss of capital
When a company produces a negative long-term return, the reasons can be traced to one or more of three sources: operational risk, financial risk and valuation risk.
Operational risk is the risk that a company’s business performance is impaired by the decline of the market that it serves or its competitive position is weakened leading to disappointing revenue growth, profit margins and cash generation. Over the long run, the vast majority of companies have a limited lifespan. Consider the fortunes of Kodak or Sears that saw their respective markets impacted by changing technology or new competitors to which they failed to respond. In this era of accelerating disruption, this has never been more important. Our thematic process identifies those companies that benefit from growing markets and avoids those exposed to challenged industries. Our company research notes consider the competitive dynamics of the relevant industry and the reasons the company can retain attractive returns on capital. Long-term investors must also consider the risks companies face from environmental and social factors and our embedded stewardship analysis is essential to understanding these.
Financial risk is the risk that the cash generated by a business is insufficient to meet its liabilities such as debt, leases, or pension and medical obligations. Companies with operational challenges are more exposed, but even reasonable businesses that have cyclical end markets and too much leverage can rapidly get into difficulties and need to raise expensive financing. More concerning are companies that do not have prudent accounts or misallocate capital. History is littered with examples of companies that have failed such as Enron, Lehman Brothers and more recently Carillion as the result of weak accounting and excessive liabilities. Our in-depth analysis considers the financial health and quality of accounting of all potential investments and the team takes a safety first approach.
Valuation risk is the risk that the market values a business at a price that cannot be sustained even if the company delivers the operational and financial results that could reasonably be expected of it. For example, in 2000 the market valued Cisco at in excess of $530 billion, more than twice the current capitalisation. Since 2000 Cisco has maintained a healthy profit margin and nearly doubled sales but it is clear that the valuation back then was excessive. We take a disciplined and long-term approach to valuing companies, combining discounted cash flow, an assessment of the sustainable cash flow return on investment and traditional multiples. Our valuation models include a scenario analysis and we look for a reasonable margin of safety and an entry price that is skewed to the upside.
Finally, we recognise that we represent minority shareholders in the companies in which we invest. As a result, our embedded stewardship analysis and engagement emphasises good governance. We meet frequently with the management of the companies in which we invest and take a close interest in the allocation of capital, management incentives, compensation and succession planning.
Meeting your investment objectives
A portfolio is a collection of stocks, just as the stock market is a market of stocks rather than an index. Where permitted when creating global equity portfolios, we take an unconstrained approach. Traditionally global fund managers build a portfolio by reference to an index, diversifying by country and sector. Our approach is to diversify by theme and ensure that risk is primarily managed stock by stock, as described above. We do not invest in companies simply because they are large constituents of an index; some would consider it ‘risky’ not to own such stocks in a portfolio. Here they are really referring to their own ‘career risk’.
We ensure that it is the themes and stocks in the portfolio that drive superior and differentiated returns. We do this by building a portfolio that seeks to minimise factor risk. Factor risk is the risk that cannot be attributed to the specific, or idiosyncratic, stock risk. These factor risks include style (such as growth, quality, value, momentum) and other risks such as currency, sector, country or liquidity risk. We minimise factor risk by diversifying the characteristics of the stocks in the portfolio, achieving a balance between companies at different phases in their development and the cyclicality of their operations. Stock liquidity is a consideration, but as long-term investors, we consider this as marginal risk that does not necessarily need to be avoided.
Bringing it all together
Our investment approach is a combination of attractive long-term themes, embedded stewardship, rigorous fundamental analysis, and thoughtful portfolio construction. This allows us to take a long time horizon, minimise portfolio turnover, optimise for risk at each stage of the process and ensure our stock selection drives portfolio returns.
In an era of accelerating disruption, we believe this is essential, particularly as central bank support for asset prices is gradually withdrawn.