I want you to think about risk in today’s letter. By the time you finish reading it, my goal is for you to improve the performance of your portfolio dramatically, and to teach you how to view risk altogether differently than you have thus far. Lastly, it is meant to be so simple that you can share the ideas with your loved ones, so that they too can become outstanding investors.
The most important thing to remember about the best performing portfolios is that the manager’s obsession with understanding risk, recognizing risk, and controlling it, leads to the most reliable and consistent results.
Risk management is the No.1 way to avoid loss of capital. Before an investor does anything else, he needs to contain the risk of losing money permanently, not temporarily.
In other words, a position, which is down compared to the price you paid for it, is not risky. What is an absolute danger to your financial well-being is a position, which has a low probability of coming back or surpassing the price you paid for it.
Look at this chart:
Investors, who purchased shares in 2004, saw five consecutive years of trading sideways, then the Great Recession hit and their position declined from $37.00 per share in 2004 to $28 per share in 2009.
Ask yourself what the average investor would do in light of this situation, and you’ll quickly visualize him selling in disgust, forfeiting his ownership stake at McCormick, though he knows the company is growing and selling more spices annually than any other business.
But, the contrarian investor, who knows that his purchase price in 2004 was reasonable, would not sell.
He would either hold or use this period to accumulate more, and he would be right on the money.
In 2004, dividends were $0.14 per share, while five years later, they were already $0.24 per share. This is a 71% increase in payouts.
To make it even sweeter, in 2004, you paid $37.00 for that $0.56 annual income ($0.14*4), so your yield was 1.51%. In 2009, buyers received $0.96 annually ($0.24*4) and paid $28 per share, so the yield was 3.4%, a 125% bump.
At present, McCormick is paying $0.52 per share, so if you held on, your 2009 yield is now 7.4%, alongside your equity position, which has quadrupled nearly four-times.
The key to identifying risk from the outset is to spot investment styles, which are becoming popular, then.
Avoiding those eliminates the possibility of overpaying, which can make a great business choice turn into a lousy investment choice. Microsoft is one of the best-performing stocks of all times, but if you bought in 1999, it would have taken you 13 years to recoup your principal and get back to ground level.
From now on, do not invest in any popular trend.
Secondly, in order to achieve outstanding performance by becoming risk-obsessive, you must understand that prices of assets are not efficient measures of safety.
This is important to remember. If an asset rises in price, it doesn’t mean it is a great idea or that it is less risky. To the contrary, it means that buyers are overwhelming sellers and the trend will eventually reverse. Your role, as a sophisticated investor, is to look to pay the least amount for a business, which is cheaper than its intrinsic value and has a possibility of returning to it in a reasonable timeframe.
In other words, the fact that a stock declines by 20% makes it cheaper, but not cheap.
For an investment to become cheap, it has to trade below intrinsic value.
Take a look at this:
In 2008, Intel shares halved. The world’s dominator in chip manufacturing traded, at its low, for $12 a share. For reference, in 1999, a decade sooner, a much smaller Intel traded for over $70 per share.
But, it wasn’t only the Great Recession, which caused investors to sell INTC shares, while they were priced at their best valuation; it was a fad termed “the end of the PC.”
An idea caught on that tablets were going to replace personal computers completely and that Intel was doomed to fail. The 2nd principal in controlling risk is to only stick with investments that are out of favor and are seen as more obsolete than they indeed are.
As you can see, INTC has soared 433% since 2009, which makes it far riskier today than it was back then.
So far, our two main conclusions are to avoid selling just because an investment is not performing well, but has no immediate fundamental risks, and to only invest in out of favor sectors, where the asset is cheaper than intrinsic value.
My third and final way of controlling risk, which I see as paramount for having a rich experience in the market over time, is to be open-minded.
There is no greater risk to any one of us than to close our minds to how others view the world around us.
No one has given us priority to divine wisdom, so we must realize that the more we think we know, the less we really do.
This is another way of saying that investing is cyclical, and we must respect these patterns.
Nothing exemplifies cyclicality like commodities do.
But, here’s where risk becomes elevated – sentiment statements, such as:
“Every year, there are more people driving cars, so the price of oil must go up.”
“Technology has found a way to extract shale oil. The price will keep going down for good.”
“Fiat currencies are worthless. Gold is headed to the moon.”
“Cryptocurrencies are replacing gold. It is no longer needed.”
These are all signs of excessive bullishness or exaggerated bearishness. None of them are productive. Commodities are cyclical, so to eliminate risk, we must avoid any of them when they become a “Must-Own” and back-up the truck when they suddenly are irrelevant.
Eliminating risk, then, revolves around being a contrarian.
The first major investor to buy bank stocks in 2009 was Buffett. The price for Bank of America, for instance, was $4-$5 then and is $30 now.
Most investors weren’t tolerating bank stocks, but Warren has seen the U.S. economy since the early 1940s, and that experience gave him the confidence to pull the trigger when others were throwing in the towel.
To lessen your risk, be ready to invest, and feel uncomfortable with it, since no one else will be joining you.