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The plurality of risk
Warren Buffett has delivered outstanding return with very low risk  

Rohit Chauhan

Warren Buffett is known as one of the greatest investors of all time and this claim to fame comes from the 20.5% annualized increase in the market value of his storied company – Berkshire Hathaway over a 53-year period.

What is not given equal attention is the low risk, with which he has achieved this result. Consider this – The book value of his company (which he uses as a proxy of value) has dropped only twice during this period, 6.2% in 2001 and then 9.6% in 2008.

This superior risk-adjusted return should not be a surprise to anyone who has followed him and read his annual letters closely. Mr.Buffett has regularly spoken about risk over the years. Let's look at some of his comments and how we can translate those to our own investing.

Defining risk

As per academics, beta which is a measure of a stock’s volatility,should be taken as a proxy of risk. This definition of risk makes sense, if one is a short-term trader, but completely useless for a long-term investor. Buffett has called this a bad measure of risk and has written so in his 2011 annual letter

The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period

In my view risk is multifaceted and cannot be boiled down to a single number. I am going to list the various types of risks Buffett has referred to in his annual letters and will try to explain them with examples. I will also share a framework to think about risks in making investment decisions. 

I am going to break down an investor’s risk into two parts – those faced by investor at an individual level and the business related risks of a specific investment.

Stage of life risk

From the 2010 annual letter:

The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to business and guides our every action at Berkshire. Charlie and I have no interest in any activity that could pose the slightest threat to Berkshire’s wellbeing.(With our having a combined age of 167, starting over is not on our bucket list.)

This is a widely understood form of risk – As one grows older and approaches retirement, the capacity to bear risk reduces. As a 25-year old, one can afford to lose a large portion of one’s portfolio and can still recover from it as one has a long working life ahead.

There is also a form of leverage risk which comes with age. Leverage is commonly understood as debt taken by an investor. I prefer to expand this further and consider all forms of non-investing leverage. For example, if you have a home loan and other fixed obligations such as education of your children (which is a form of quasi debt), then your flexibility as an investor is greatly reduced.

It makes sense to manage these risks by having a high equity allocation early in life, which should then be tapered down as one gets older and needs stability of cash flow.

Inflation risk

Warren Buffett has spoken extensively about this risk over the years in his annual letters. He wrote an article on this topic in Fortune magazine in 1977: ‘How inflation swindles the equity investor’. I think that article is a must-read for anyone trying to invest money.

Inflation is a very slow and stealthy form of risk where one thinks that his money is growing via fixed income instruments, but in reality, one is falling behind in terms of buying power.

This risk comes to bite you at absolutely the wrong time – retirement. At that time, you realize that your nest egg is not enough to take care of all your spending needs. In such cases, in absence of a social safety net, one either has to continue working or depend on others.

Inflation risk can be managed by investing a portion of assets in equities – directly or via mutual funds which brings us to the next type of risk

Temperament risk

Not everyone has the temperament to invest directly in companies.

From the 2006 annual letter:

Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipeout a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success.

This is a rarely discussed risk. There are some people who are temperamentally more suited to the stock market as they are calm, humble and eager to learn. Such people do well over the long term.

On the other hand, you will often find people who are impatient and bring a level of arrogance to the stock market. They seem to believe that the stock market owes them high return. As a result, they assume that all they need to do is to buy any stock and money will start rolling in. Such people are often disappointed.

The cliché ‘know yourself’ is very true in the stock market if you want to avoid an expensive lesson. If you don’t have the right temperament to invest directly in equities, then the next best option is to do so via mutual funds or Index ETF with help of a financial planner.

If you do have the right temperament to invest directly in equities, then one must keep in mind the following business specific risks:

Management risk [Poor quality management]

From the 1989 annual letter:

After some other mistakes, I learned to go into business only with people whom I like, trust, and admire. As I noted before, this policy itself will not ensure success: A second- class textile or department-store company won't prosper simply because its managers are men that you would be pleased to see your daughter marry. However, an owner - or investor - can accomplish wonders if he manages to associate himself with such people in businesses that possess decent economic characteristics. Conversely, we do not wish to join with managers who lack admirable qualities, no matter how attractive the prospects of their business. We've never succeeded in making a good deal with a bad person

This is a risk, commonly accepted but least followed by a lot of investors. If you talk to someone who has been investing in the market for a period of time, they will agree that it is important to invest only with high quality management.

Let’s define ‘high quality’, which I like to think of on two parameters:

Capital allocation and distribution – does the management allocate capital at high rate of return in the business and distribute the excess to shareholders via dividends?

Ethical behavior towards all stakeholders – Does the management behave ethically or treat other stakeholders (such as customers, employees, shareholders etc.) in a manner they would like to be treated if the roles were reversed?

The first parameter is objective in nature and can easily be verified by looking at the return on capital of the business over an entire business cycle. The second factor is far more difficult to evaluate and needs careful study of the management’s actions over time. Again, it is not easy to define the right behavior in several cases such as high compensation or bending regulation to gain an undue advantage in business.

Even if we leave aside some of the fuzzy stuff, in a lot of cases it is easy to just reject a company if several red flags pop up. In the end, my own experience has been that if you ignore this risk, it eventually catches up. Any investment with unethical and incompetent management may not go south, but over time the law of averages work and the overall result at a portfolio level will be poor.

The only way to mitigate this risk is to avoid such companies. It will prevent a lot of anxiety, heartburn and sleepless nights.

Capital structure risk

A company with a high debt-equity ratio is generally a riskier company. What is ignored sometimes when evaluating this risk are the hidden liabilities which are the equivalent of debt, even though they do not appear as such on the balance sheet.

Take the example of airlines - airplane lease and other fixed costs such as salaries and airport slot fees, are a form of quasi debt. The deadly combination is when some form of business risk hits a highly indebted company resulting in bankruptcy

How do you mitigate this risk? Learn to read the balance sheet carefully and understand all forms of fixed obligations which cannot be reduced even if revenue goes down. Try to answer the question – How long will the company survive if its revenue drops 20%.

Regulatory risk [earning excess returns from favorable regulation]

From the 1996 annual letter:

But my analysis of USAir's business was both superficial and wrong. I was so beguiled by the company's long history of profitable operations, and by the protection that ownership of a senior security seemingly offered me, that I overlooked the crucial point:  USAir's revenues would increasingly feel the effects of an unregulated, fiercely-competitive market whereas its cost structure was a holdover from the days when regulation protected profits.  These costs, if left unchecked, portended disaster, however reassuring the airline's past record might be. 

If a company can make above average profit due to a favorable regulation, then it is exposed to this risk. We have a recent example of an airline facing a similar situation – Jet Airways. Anyone who has read through Buffett’s letter can see the parallels here.

I have noticed that the market is usually sanguine about this risk and it is generally not priced in. However, if it materializes, the reaction is swift and brutal. The only way to mitigate this risk is either to avoid such companies altogether or hope and pray that the regulator/ government does not change its mind on the key regulation.

Reputation risk [earning excess return based on reputation/ brands]

From the 2010 annual letter:

The priority is that all of us continue to zealously guard Berkshire’s reputation. We can’t be perfect but we can try to be. As I’ve said in these memos for more than 25 years: “We can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation.”

This is a key risk in businesses which depend on the reputation of a brand or a company. If the company earns an above average profit due to a favorable image or brand, then it is very important for the company to safeguard the brand.

If there is some incident where the brand image is impacted, management should react swiftly and prevent further damage to it.

Case in point – The lead contamination incident with Maggi Noodles in 2015.  Irrespective of the merits of the case, the response of the company to the issue and subsequent recall was slow. The issue surfaced in April and the company finally responded in June when the issue blew up in the media. This is a $1.2 billion brand and the management did not react to the situation till it finally got out of hand.  Net result – The company lost close 20% of its market cap in the aftermath.

Change or obsolescence risk

Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it's the lack of change that appeals to me. I don't think it is going to be hurt by the Internet. That's the kind of business I like."

Source: Businessweek, 1999

This risk is especially relevant in industries where the underlying technology is going through a lot of change. 

Think of telecommunications – this is a fast-paced industry which needs a lot of investment, but at the same time the underlying technology keeps changing rapidly. Is it easy to predict what will be the shape of this industry in 2025 with new technologies such as 5G, Broadband, Wi-Fi etc on the horizon?

The way to mitigate this risk is to have a very deep understanding of the industry, monitor the change closely and not overpay for the stock. If you do not have any specialized understanding of such an industry, it is best to stay away – discretion is often the better part of valor in investing.

How to think about risks

You would have noticed that I have not used any Greek letters to measure any of the risks. It should be obvious that these academic measures do not represent the risks for a company.

My approach to evaluating risk is usually as follows:

  • Have a checklist of all the above risks and use it to identify which of these risks are relevant for the company.
  • Try to dig deeper into the critical risks for the company and understand its key drivers and how it could hurt the company and its valuation
  • Evaluate the upside from the bull case of the company versus the downside from all the risks facing the company. If the downside risk is too high, then I just move on to the next idea.
  • Also look out for aggregation of risk. Is there a risk, which could impact seemingly different companies in your portfolio at the same time?

Combination of risks

It is not enough to understand the individual risks for a company. One must consider all the risks together and evaluate the joint impact on a company. In addition to this, one needs to also consider the personal risks at the same time.

Let me give an extreme example to make the point:

Let’s say you are a 40-year old with a housing loan and other family obligations. These obligations accounts for almost 90% of your income leaving you with not more than 10% surplus capital to invest. In such a scenario, you do not have a lot of flexibility to take a lot of financial risks if your savings are not too high.

An investment in a leveraged telecom company would not be appropriate for you. A large drop or bankruptcy of such a company is not something you can bear at this stage of life.

On the flip side, a young person in his early 20s and working in the technology field with specialized knowledge can afford to invest in a young technology-oriented start-up in that area of expertise. If the investment opportunity works out, it would make a sizeable impact to his net worth. If it fails, he or she has a long working life ahead of them with minimal obligations in the present.

Unlike academics, Buffett over the years has taught us through his letters and interviews that risk is multifaceted and plural, which cannot be boiled down to a simple formula. Inspite of its complexity, one can intelligently think about risks and manage them. Failure to do so, can be injurious to your financial health.

In Buffett’s words, “To finish first, you must first finish”.

The writer is a value investor and tweets at @rohitchauhan .Sectors/Stocks discussed are for educational purpose only and not recommendations to buy or sell. Please read disclaimer towards the end of valueinvestorindia.blogspot.com

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