Chapter 5

Risk and Uncertainty

Is this a game of chance? Not the way I play it.

W.C. FIELDS

EVERY INVESTMENT situation involves an element of risk. Something can always go wrong. The investor can, of course, work to understand and minimize the risks inherent in his financial activities, but he cannot hope to eliminate them.

The omnipresence of risk may seem all too obvious to the reader. Many outsiders, though, seem to believe that some investors—specifically insiders—can wholly avoid uncertainty and risk. Even the insider who obtains outstanding bargains cannot do so without a degree of uncertainty. (Consider the F. & M. Schaefer Corporation discount purchase, detailed in Appendix I.) To say, then, that insiders get a “free ride” is far from the truth. They usually assume risks when they invest in securities. It is true, however, that the outside investor faces greater risks and uncertainties than the insider, for a number of reasons.

For one thing, the outsider cannot acquire complete knowledge of a company, no matter how many documents he studies or how intimate he is with management. Even in the case of investment trusts registered under the Investment Company Act of 1940, which are subject to the most complete public disclosure requirements in existence, the outside investor sees only quarterly portfolio transactions. He cannot find out about day-to-day investment changes. In fact, if by some chance he did find out about them and chose to act on the basis of his knowledge, he would assume the risk of possibly violating the antimanipulative provisions of the securities laws.

Aside from the handicap of incomplete knowledge, the outsider (and the insider as well) is always faced with the possibility that his analysis is wrong. This may be due to out-and-out error, such as a failure to account for some crucial factor in an evaluation of a company. For example, in 1972 one of the authors recommended Okonite subordinated bonds, which were the principal debt of Okonite Corporation. The debentures were selling around 42, to yield about 13 percent. Okonite appeared to be a financially capable and strong issuer. What the author failed to take into account, though, was that Okonite’s parent, Omega Alpha, a weak, bootstrapped company, could merge Okonite into itself without obtaining bondholders’ consent. The merger did occur. The debentures may or may not eventually have a workout value exceeding 42, depending on the outcome of Omega Alpha’s Chapter X bankruptcy proceedings.

Analysis may also fail because of a misappraisal of management. Such appraisals are crucial in many areas of financial analysis and especially in the field of emerging securities. We do not know, however, of any reasonably objective standards by which to judge whether a management is “good,” except for the standard of honesty. American Telephone’s management may be fairly good for running Telephone; it would be horrible for Vindale, a sectional-home manufacturer.

Even if the outside investor avoids errors in his analysis or appraisal of management, he may still turn out to be wrong, simply because the future is unpredictable. The cash-return investor who buys a broad range of long-term, high-grade, income-producing securities may find that high interest rates caused by a tight money market substantially depress the market value of his investment, as was the case from 1966 to 1975. Or an investor using the financial-integrity approach may find that the company whose common stock he has chosen has dissipated its assets. An example is the experience of Pacific Coast Properties in the mid-1960’s. That company had a highly sophisticated and very well regarded control group with a long record of success, and it enjoyed a huge cash position. The company loaned the bulk of its surplus cash to VTR, a marginal company. When VTR defaulted, Pacific Coast Properties common stock plummeted from $10 to about $1, and the company, now heavily burdened with debt, has asset holdings (primarily California real estate and a large tax-loss carry-forward) which may have little or no net value.

Finally, even if the outsider is correct in his analysis that a security has large intrinsic values that are not dissipated, there is no certainty that he will ever be able to realize these values. For one thing, the values may not be reflected in the stock market for an indefinite period of time. For example, U.S. banks and utilities have enjoyed steadily rising earnings and dividends (as well as revenues and net asset values) over the past decade. Yet in 1974, Standard and Poor’s 60 Utility-Stock Average ranged between 40 and 24, as compared with a range of between 60 and 51 in 1961. Price-earnings ratios had shrunk during the interim, and sixty Utilities that had sold at from nineteen to twenty-five times earnings in 1960 sold at only six to nine times in 1974. It sometimes happens too, as we have pointed out before, that sound investments fail to prove attractive because active financial operators preempt the intrinsic values for themselves by effecting force-out mergers or similar corporate events at a time when a stock’s price is depressed or underpriced because of relatively recent developments within the business.

The uncertainty that results from the outside investor’s incomplete knowledge—and from the possibilities of erroneous analysis, adverse future developments and the preemption of intrinsic value by others—can never be eliminated. Rather, the goal is to tip the risk-profit equation as far in favor of profit as possible, and we believe that intelligent use of our approach achieves this result. In tipping the scale toward profit, it is useful to have an understanding of the separate elements that go to make up investment risk.

ASSESSING THE INVESTMENT ODDS: RISK AND REWARD

Conventional wisdom tells us that the key to investment risk is the quality of the issuer. A high-quality, or primary, issuer is most commonly defined as a large, well-known company, popularly recognized by others as a high-quality company, with a long record of dividend payments on its common stock. Because popular recognition is crucial—indeed, probably the single most important element in the definition—the value of the issuer is, of course, likely to be reflected in the market price of its securities. It follows, then, from this conventional wisdom that the securities of lesser-known issuers, so-called riskier investments, will have greater capital appreciation potential. Thus the cliché, You have to take chances if you want to make money.

It is our view that though the quality of the issuer is important in assessing investment risk, it frequently is not crucial; still, it happens to be the key for investors who are neither knowledgeable nor diligent nor likely ever to be in a control position. But for the investor with a modicum of know-how, perceived quality of the issuer is only part of the story. Other factors that figure into calculating the risk-reward ratio are the price of the issue and the financial position of the security holder.

QUALITY OF THE ISSUER

The tendency in the financial community is to stress quality of the issuer in assessing risk, and to ignore price of the issue. Thus, the view is that there is less risk in purchasing, say, American Telephone and Telegraph common than there is in purchasing little-known stocks, such as Federated Development Corporation or Standard Shares. Perhaps the best-known advocates of this approach are Graham and Dodd, who in Security Analysis state

 

The basic portfolio list should consist of a substantial number—say, not more than 100—of primary common stocks. (These companies are large, prosperous, soundly capitalized and well known to investors) [our emphasis added]. The actual portfolio would be constructed from between twenty and thirty of those issues which, at the time of selection, showed the most favorable relation between market price and the analyst’s appraised value. Some limitation as to the amount committed in any one industry would be imposed to assure adequate diversification. If this process takes place at a high level of the market, the issues selected may actually be selling above their valuations; that would be the necessary penalty for making commitments at what appears to be a basically unfavorable time. (No doubt those who are convinced that the 1962 levels are not excessive will in their individual valuations apply multipliers high enough to make many issues appear absolutely as well as relatively attractive. Typically, they will conclude that certain promising issues are selling at thirty or more times earnings).

Our problem would allow for the substitution of secondary issues in place of primary ones—but only if the value conservatively found for a secondary issue shows it to be substantially cheaper than the most attractive primary issue it would replace in the list. By “substantially cheaper” we imply a required differential of at least 25 percent.³⁴

 

This approach is based on an implicit assumption that the market knows more about the value of a given investment than the individual investor does. Within a context that concentrates on accounting earnings as the basis for valuing a going concern, this undoubtedly has some validity. Outside investors who are not well informed about the companies they are investing in, and who are not conscious of the quality and quantity of net assets in a business, tend to find it difficult to assess the reasonableness of the price of an issue in any meaningful way. Thus, it seems prudent to weight quality-of-the-issuer considerations more heavily. For these investors who lack independent knowledge of securities and companies, it is important, too, to diversify an equity portfolio to provide a modicum of additional insurance against the possibility that the market, which is assumed to be well informed about any particular security, is in fact not.

Still, emphasizing issuers of high quality in an investment strategy does have its own special difficulties. As noted above, popular recognition is probably the single most important element of high quality. This means that a company can become high quality simply because influential people say it is. The hard facts are that many issuers that have been selected by the recognized arbiters of the financial-quality fashion parade have turned out to be quite the opposite.

For example, in the era before the 1920’s, the foremost blue chips were railroads and traction companies. Included among these high-quality issuers was the Pennsylvania Railroad, which until its 1968 merger to form Penn Central Company had a dividend record dating back to 1848. In the 1920’s, investment trusts and utility holding companies were regarded as high-quality issuers. In recent years, common stocks such as the Great Atlantic and Pacific Tea Company have been wrongly acclaimed as high quality. The damage done to investors who purchased stock based on the high-quality reputation of these issuers tended to take the form of double stock-price depreciation: first the shares went down because earnings declined; then the shares went down even more when the issuers lost their high-quality image and the high price-earnings ratios evaporated.

Notwithstanding these pitfalls, there is sufficient validity in an investment strategy based on a diversified selection of high-grade issues that an outside investor who is willing to trade infrequently and to realize only a modest return on investment will probably do moderately well most of the time. Even this investor must be careful to follow two basic rules, however. First, do not buy what is popular when it is being highly touted; this is usually when it is most overpriced. Second, if your investment matters to you, obtain at least a rudimentary knowledge of the company before you invest in it.

PRICE OF THE ISSUE

We agree that quality of the issuer may be the most important factor in evaluating risk for the outsider who is short on know-how. It is also the most important factor in risk evaluation for the cash-return investor. But for the outside investor who is reasonably well informed about the company in which he is investing and who understands the whole array of factors, including financial ones, that figure in the valuation process, quality-of-the-issuer considerations cover only part of investment risk. Because we believe economic and financial information is so good in the United States that an intelligent investor can become relatively knowledgeable, and in fact more knowledgeable than the market, we tend to emphasize price of the issue in evaluating most securities.

Smart investors, whether active or passive, tend to worry more about how much they can lose than how much they can make. In this sense, investors are truly “risk averse.” In this context, then, the higher the price of a security, the greater the risk; the lower the price, the less the risk, and so the greater the potential reward. Price-of-the-issue considerations tell us, then, that in a given situation, there is less money to lose and more money to make if you invest $5,000 in American Telephone common stock at 50 rather than at 60, or if you invest the same $5,000 in Orion Capital common stock at 5 rather than at 10. It also tells us that there may be considerably less risk in investing $5,000 in a lower-grade security, such as Orion Capital common stock, at 5 than investing in the common stock of a high-quality issuer, such as American Telephone, at 60 or even at 50.

This poses a dilemma, then. Quality-of-the-issuer considerations tell us that if you want to make money, you have to take risks. Price-of-the-issue considerations, on the other hand, tell us the opposite—that the less risk you take, the more money you can make.

We recognize that this view runs counter to an economic theory which assumes that at any moment market price reflects a rational price equilibrium between risk and reward. Where a security entails greater risk, it is assumed that it will be assigned a lower price by market forces. In contrast, the investor who analyzes risk in terms of price of the issue assumes implicitly that stock market prices are virtually always in disequilibrium.

This assumption also runs counter to the views of many in the financial community. Broker-dealers, investment companies and commercial lenders tend to steer clear of securities that have a low per-share price. Common rules tell us that low-priced common stocks (under, say, $10 per share), whether undervalued or not, are per se speculative.³⁵ Thus, many brokerage firms will not permit their salesmen to solicit orders for stocks selling below a certain price. At Merrill, Lynch, the minimum is $5. Banks as well as brokers normally will not accept low-priced stocks as collateral for margin loans.

This institutional approach of damning low-priced stocks assumes implicitly that the investor, the broker and the lending bank are uninformed or badly informed about the situation, or that the market knows more than they do. A low price is seen as strong evidence or even proof that the issue is a dangerous speculation. We do not accept the proposition that this must necessarily be, or even usually is, the case.

This is not to say that we advocate the indiscriminate buying of low-priced stock by the unwary. The conventional wisdom that warns against low-priced stock does have some objective basis in fact. For one, it is true that common stocks of formerly prosperous businesses that encounter financial problems so dire that they threaten the company’s solvency will almost invariably sell at low per-share prices, no matter how small the number of shares in the outstanding common-stock capitalization. For another, a promoter of a blatantly speculative venture, such as a uranium discovery, will deliberately price the issue at a low price, usually below $5. Finally, the trading costs involved in buying and selling low-priced stocks tend to be higher, and so detract from the investment merits of the security. These three points are obviously things the investor should bear in mind. But to take the position that one should stay away from low-priced stocks in general because they are speculative is to make the wrong deduction; for long-term investors, buying and selling costs are unlikely to be material considerations.

In practice, of course, there are shadings of judgment that investors must make about both quality and price. For example, in 1972, using the financial-integrity approach, we believed that Federated Development at 7 was attractive, combining substantial appreciation possibilities with minimum risk. Federated had an unencumbered asset value—in either cash or assets readily convertible into cash within a two- or three-year span—of not less than 17, and a management and control group that we thought were honest, capable and motivated toward converting Federated’s asset value into earning power that would be reflected in a market price that would be at a premium over a growing net asset value. Even though we favored it, we did not recommend Federated for widows or orphans who need highest-quality stocks, and would not have recommended it to them even if Federated had paid dividends. The fact that Federated did not have a continuing, recurring, profitable operation—a consideration that goes to quality of the issuer—cautioned against it as an investment for such holders. For them, the fact that Federated was attractive under the financial-integrity approach was not a sufficient condition to recommend the stock.

Parenthetically, in October 1973, an outside group obtained control of Federated by purchasing 51 percent of the stock outstanding (57 percent of the stock tendered) at $12.25 per share. Our remaining shares—that is, 43 percent of our original holdings—were sold in early 1977 at 11. Considering that no distributions were ever made on Federated shares, these investment results probably are best described as no better than reasonable.

While shadings of judgment are useful in resolving the inherent contradictions between quality and price considerations, there are insights that tip an investor’s scales toward quality and away from price, or vice versa. Insofar as an outside investor lacks knowledge, or the time or ability to obtain knowledge, quality considerations should dominate. Conversely, insofar as an investor is or can become knowledgeable, and is or can become an activist in terms of influencing corporate affairs, price considerations assume greater and greater importance.

FINANCIAL POSITION OF THE HOLDER

The third element in the risk-profit equation is the financial position of the holder. The investor who buys a stock of even the best quality at a fraction of its underlying value is engaging in an extremely dangerous speculation if he cannot afford to make the purchase.

An inappropriate financial position can arise out of borrowing too heavily to own the securities. For example, U.S. government bonds are generally regarded as a high-quality issue. For the financially weak holder who has borrowed 95 percent of the purchase price, however, all it takes is a small fluctuation to give rise to a Las Vegas-style gamble. It is not healthy for a small speculator to get caught in the cross fire between the Treasury and the Federal Reserve when his protection is a 5 percent margin and an empty bank account.

An inappropriate financial position can also arise because an investor does not have enough funds to live on. There are many examples of investors who suffer large losses in an apparently undervalued security because they do not have the financial position (or temperament) to tough it out. Many of the most successful long-term investments of the last ten years, which appreciated from five to ten times cost, were in issues which paid small or no dividends and on which the holders realized no profits or paper losses for two, three or even four years. Examples are Tokio Marine and Fire Insurance, Fargo Oils, H. J. Heinz and Northwest Bancorporation.

The wherewithal to weather a temporary setback is particularly important for the investor who believes, as we do, that he can know more about an issue than the market does. It is an important condition for investors following the financial-integrity approach. It is suicidal to ignore the general market unless you have the resources and inclination to sit tight, or can actively influence the business. Any approach that minimizes market factors can give only a margin of safety in terms of investment risk. We do not know how an outside investor can guard against stock-price fluctuations unless he has the resources to ignore them.

PORTFOLIO DIVERSIFICATION VERSUS SECURITIES CONCENTRATION

As pointed out above, it is logical where measures of risk are based on quality of the issuer that portfolios of such securities be diversified, providing added protection to compensate for lack of knowledge about individual securities. In contrast, the investor who, because of know-how or control, has confidence in an equity investment based on price of the issue, and who has a financial position that will allow him to survive the short term, does not need the extra protection that comes from diversification. Such protection comes from a lack of encumbrances upon the investor. He stands to gain most from concentrating his investment in the area where his knowledge (and perhaps control) tips the risk-reward ratio for the particular security very strongly in his favor.

CONSIDERING THE CONSEQUENCES

Astute financial people do not measure potentials simply by reference to the risk-reward ratio. It is not sufficient to calculate that, say, there is five times as much chance that the investment will appreciate from one to twenty points as there is that it will depreciate from one to twenty points. Such a calculation reflects only odds.

The astute person examines consequences as well as odds. For example, consider the situation where the odds are five to one that an investment will appreciate, but that if it fails to do so, the investor will become insolvent. He might well conclude that the consequences of disappointment are so dire that the particular investment is unattractive, notwithstanding the favorable odds.

This “consequences” view of risk is another way of looking at some essential, practical limitations in finance. Most companies, institutions and individuals tend to (and should) be limited to things that are affordable.

RISK AND INVESTMENT OBJECTIVES

Don’t go out with chorus girls or buy second mortgages.

ADVICE OF DYING FATHER TO HIS ONLY SON

Investment objectives figure into the risk-measurement process in two ways. First, the cash-return investor will base his investment decision on different factors in evaluating risk than will the workout special-situation investor, even where both of them use the same factors (say, the four elements that make up the financial-integrity approach) for part of their analysis. Second, the risk-reward ratio will provide the investor with a guide to use in defining his investment objectives.

The investor who is interested primarily in cash return and is in no position to investigate carefully should emphasize first and foremost, and perhaps exclusively, quality of the issuer. The definition of high quality entails two factors: first, there should be a general recognition by others such as bond-rating services that the issue is high quality; and second, the investor should reach a similar conclusion after independent analysis, however cursory. If there are any doubts about the safety of the cash payments to be made to owners of the cash-return security, then that security should not be bought; if owned, it should be sold.

In most cases, a strictly cash-return investor should limit his portfolio investments largely to debt securities. This is because the holder owns a legally enforceable right to be paid principal and interest by the issuer and any guarantors in accordance with specified contractual terms, affording the cash-return investor a margin of safety.

In contrast, a workout- or special-situation investor emphasizes price of the issue rather than quality of the issuer. It is not that the special-situation investor sacrifices safety for yield, but rather that he finds safety in a low price. This approach, in contrast to the conventional one, involves hard work and a large degree of know-how. The basic philosophy is that as a result of study, the investor will know more about the particular situation than the market does. The workout-situation investor does not rely on general recognition. It is our view that the most successful of these investors tend to place important, but never sole, emphasis on the four essential elements of the financial-integrity approach.