June, 2024
Robert Currie, CFA
Risk is often associated with price volatility. This article takes a closer look at two types of risk that could help you avoid bad investments.
Pointing out bad investments is usually a post-mortem practice. For example, you might hear a friend talk about how they know someone who lost their money making “bad investments”. Because the industry is relatively esoteric, we end up conflating terms for the sake of simplicity. Under this guise of simplicity, the term “investment” covers anything from your nephew’s new pizzeria to Apple’s common shares sold on the New York stock exchange. This can sometimes make talking about investing complicated as it means different things for different people.
It goes without saying, but a sure way to make good investments is to avoid the bad ones. This is where things get complicated as a bad investment is easy to identify after the fact but be very difficult in advance. This is where we introduce another overused and ill-defined term in the investing world: “risk”.
Risk sounds like the precursor to a bad investment, but that is the wrong way to think about it. In fact, Aswath Damodaran of NYU has this to say in his book Strategic Risk Taking: “… financial theorists and practitioners have chosen to take too narrow a view of risk, in general, and risk management, in particular. By equating risk management with risk hedging, they have underplayed the fact that the most successful firms in any industry get there not by avoiding risk but by actively seeking it out and exploiting it to their own advantage.”
Risk and return go hand-in-hand and when someone is contemplating an investment, they should understand the opportunity as a balance between risk and return. Risk is typically measured by academia as the price volatility of an investment. I find this a very poor way of measuring risk. A much better way of measuring it is to measure the variability in possible intrinsic values for the investment.
The intrinsic value of an investment is the sum of its future cash flows (“CF”), which could be as complex as the future cash earnings from a business you are investing in or as straightforward as the periodic interest and maturity payments on a bond you wish to purchase, adjusted downward for the associated cost of risk (“r”), more commonly called cost of capital or the discount rate. That downward adjustment is amplified by how far in the future the cash flows occur (“t”):
Intrinsic Value = Σ CFt (1+r)t𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑉𝑎𝑙𝑢𝑒 = 𝛴 𝐶𝐹𝑡 (1+𝑟)𝑡
A risky investment in this context is one with a high degree of uncertainty in any one of those variables. And typically, the more uncertainty there is around the cash flows and the timing, the higher the cost of capital should go. To link this to Damodaran’s quote, evaluating the quality of an investment (the probability of it being a good investment) can be thought of as identifying mispriced risk.
There are many types of risk, but there are two easy ones to avoid as they are very difficult to measure, making the investment very difficult to value, reducing the probability it is a good investment.
First: too much leverage. Debt is an amplifier. It can make some investments offer incredible return and others go to zero. Think of the value of your home. If your personal residence was purchased for $100, but you put in $20 of your own (equity) and borrowed the other $80 (debt), a 20% drop in the value of your home would completely wipe out the equity because the value of your debt does not change. Stocks are equity investments in publicly traded companies and the same math applies. If you overestimated the future cash flows of a company, there is little room for error when too much debt is applied.
Second: speculative investments. I categorize speculative investments as those with significantly higher-than-average uncertainty. Bitcoin is a great example. What is the expected future cash flow of Bitcoin? The only cash flow it produces is the cash you receive when you sell it. Therefore, the intrinsic value is almost impossible to calculate. Biotech companies in the preclinical or clinical trial phase also fit this description, as well as junior mining companies, small money-losing technology firms, etc...
If you feel you have found an investment that uses a lot of leverage OR has a high degree of uncertainty in its future cash flow profile, you’re likely better off avoiding it or doing it in appropriately small size. There are exceptions to every rule, but one should have a strong reason to budge on (or accept) these risks when investing.
This writing is for general information purposes only and is not intended to provide legal, accounting, tax or personalized financial advice. For complex matters, you should always seek help from a professional. Any opinions expressed are my own and may not reflect those of Louisbourg Investments.
Author:
Robert Currie, CFA is a Portfolio Manager with Louisbourg Investments. Comments or questions may be submitted to Robert at robert.currie@louisbourg.net.
This writing is for general information purposes only and is not intended to provide legal, accounting, tax or personalized financial advice. If you are not sure how to proceed with a request for further information, seek help from a professional. Any opinions expressed are my own and may not necessarily reflect those of Louisbourg Investments.
Comments