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While most investors focus primarily on investment returns, I have recently shifted my attention to risk. Recouping a serious loss of principal takes many years of outperformance and is psychologically demanding, hence I would prefer to avoid it.

Basically, there are two different approaches to risk of investing in the stock market. The first approach essentially equates risk with volatility and uses statistical measures computed from historical data to evaluate risks; the main proponents of this approach are academic researchers.

The second approach is based on studying the underlying business from an entrepreneur's viewpoint. This approach is used by many investment professionals and famous investors, e.g. Warren Buffett (see his views on business risk versus volatility). A nice comparison of the two approaches can also be found in articles by Chuck Carnevale.

Academic approach

According to the academic research, there are two types of risks:

  • systematic risk: which is compensated for by higher expected returns;
  • unsystematic (or idiosyncratic) risk: which can be diversified away and so one gets nothing for assuming this type of risk.

Systematic risk is related to the asset class: for instance, the returns expected by owners of stocks are higher compared to the returns expected by owners of bonds because stocks carry higher risk; that is, there is a positive risk premium for being invested in stocks instead of bonds. An example of idiosyncratic risk is putting all your money into a single stock. While you can minimize exposure to various other kinds of risks in this way (e.g. you can avoid exposure to the volatility of commodity prices by investing in a bank), you still have to assume the risk that your analysis of the company missed something crucial.

The conclusion of the academicians is that one should not assume risks he is not compensated for (check some articles written by Larry Swedroe). That is smart, of course, and Buffett thinks the same. However, one first has to understand what risk really is, and I do not think it can be measured by a single number (or a set of a few quantitative indicators). I have two main objections to the academic approach.

First, the expected return is a function of the stock price. If I expect earnings of $5 per share, then I expect a 5% return if the purchase price is $100, but a 10% return if it is $50. Thus the lower the price, the higher the return. In addition, the risk is actually decreased when buying cheaper. Assume that one share of the company is backed by, say, $100 of net assets. If the actual profit turns out to be -$20 instead of $5, then the net assets decrease to $80. However, I have paid $100 in the first case and only $50 in the second, which means a real loss in the first case, but no loss in the second.

Second, risk premiums depend on demand: if most investors are risk-averse and prefer bonds to equities, the equity risk premium will be very large because the returns on bonds are drawn down by the high demand. This psychological trait of investors might have nothing to do with business prospects and future earnings of companies. There is also the question of the so-called risk-free assets which occasionally turn out to be of very poor quality. Consequently, it is unclear whether the risk premium actually corresponds to some real-world risks. (Academic researchers are not sure about that too: check the story of the value premium).

In conclusion, while market prices usually reasonably reflect future earnings prospects, the risk often gets mispriced. An example of this are large-sigma events notoriously occurring every few years. Another example can be found with popular companies like Tesla or Amazon: speculators have bid the price so high that it is barely justified by earnings even in the very optimistic scenarios for the underlying business. In other words, an investor assumes plenty of potential downside without being compensated for it. On the other hand, one can sometimes buy an individual stock so cheaply that the expected return more than sufficiently compensates for the risk of investing in an individual company.

It is not that the financial academic research was completely useless. It is just that they need a lot of time to understand things. For instance, recently they have figured out Buffett's investing strategy and found out that anyone can replicate his results by using cheap insurance leverage and by investing in quality companies with small earnings volatility. However, Buffett has openly used the strategy for about 50 years and it has been known for even longer (check the books by Benjamin Graham and Phil Fisher). Perhaps the academicians won't need more than another 50 years to understand and confirm his views on risk...

Business fundamentals approach

Another way of evaluating investment risk is based on underlying business fundamentals. Ben Graham's concept of margin of safety is the most powerful idea here. An investor should first conservatively calculate an estimate of the fair value of the business and invest only if the current market price is much lower then the calculated value. The margin of safety thus created helps in two ways: the expected returns are higher and the risk of being wrong is less harmful. (Note that while we do not decrease the probability of disasters occurring, we decrease our loss in case they do occur.)

The crucial question is how to calculate the fair value estimate. Basically, one can do a discounted cash flow calculation. There are two problems: first, how to determine the discount rate; second, how to predict the growth rate of earnings. I believe that the discount rate should be the return I would like to obtain, which is 10% in my case. (I will reconsider this value if interest rates go much higher; in fact, I mostly use the calculated estimates to compare possible investments against each other: I prefer those with the largest margin of safety.) I do not believe that one can account for increased unpredictability of future earnings by using a higher discount rate. If we take a discount rate in the range of 20-30%, it might well reflect the uncertainty, but the resulting valuations are too small and most enterprises will never trade so cheaply.

Because of the problem of estimating earnings growth, the calculation is useful only if future earnings can be predicted with a sufficient degree of certainty. This almost automatically excludes certain industries---it is not that Warren Buffett would be too dumb to understand what a smartphone can do; the trouble is he simply cannot figure out who will produce them 5 or 10 years from now. And I do not believe anyone can. Consequently, a DCF calculation is rather meaningless for many companies.

Criteria for avoiding risky stocks

Finally, I will present my criteria for selecting low-risk companies. This list is inspired by Buffett's filters, and so is the action taken for companies not meeting the criteria: put them in a "too hard" pile and don't waste time researching them.

I am avoiding companies with the following characteristics:

1. Unclear how cash is generated and what is the potential downside: This becomes less and less restrictive as I learn more.

2. High risk of a single event crippling the company: Nuclear operators, oil producers, single-plant companies, companies operating only in politically unstable regions etc.

3. Earnings too unpredictable: Too hard to determine the intrinsic value. I try to roughly estimate earnings for at least 10 years. This category comprises mostly high-tech companies, non-diversified commodity producers with volatile earnings, and companies chasing consumer trends.

4. Quarrelling major shareholders: I have added this because of my experience with Turkcell Iletisim Hizmetleri (NYSE:TKC)---they stopped paying dividends because of major shareholders disagreements. Moreover, there is the risk of the company being taken private by some of those shareholders, resulting in a loss for a small investor if done at a period of weak market prices.

5. No justifiable competitive advantage: The advantage should be visible from margins and other historical data, not just based on someone's opinion. This criterion also excludes companies without a reasonably long track record.

6. Untrustworthy management: One that is lying, not disclosing enough information, cooking books, managing company for their own profit at the expense of the shareholders etc.

If a company meets my criteria, I roughly determine its fair value and then wait until the stock price allows me to buy it with at least 10-20% margin of safety. Of course, qualitative criteria cannot be screened for, but there are plenty of companies meeting them, so one can start with a simple screen for companies having a reasonable P/E ratio, nice margins, manageable debt and some record of increasing earnings. Examples of companies meeting my criteria and available at reasonable prices include BIP (see my analysis), OTCQX:BASFY (analysis), OTCPK:TSCDY (analysis) and Berkshire Hathaway (BRK.A, BRK.B), which is a prime example of a company managed first to minimize risks and only then to enhance returns.

I have identified the following measures taken to minimize risk at Berkshire.

1. Never write an uncapped insurance policy; this gives protection from a complete wipe out.

2. Sound insurance underwriting policy: "We're OK with losing a lot of money, as long as we're being paid appropriately for the risk." BRK does not try to increase volume if prices are inadequate.

2. Keep at least $20B of cash to guarantee payments of extraordinary insurance claims.

3. Do not invest using borrowed money. (Check the story of Rick Guerin for an example of harmful leverage).

4. Invest with margin of safety and only in things you understand. As Buffett says, "Risk comes from not knowing what you're doing." He maintains a firm circle of competence and a big "too hard" pile. I believe his successors will follow the same approach.

5. Get at least a dollar of value from each reinvested dollar. Subsidiary CEOs have a high hurdle rate for capital investments; this limits poor-quality acquisitions which often occur when companies are trying to grow just for the sake of growth.

6. Buffett is adding operating businesses to mitigate the risk of his death. He is also adding capital-intensive businesses so he can deploy tons of cash at a fair rate of return instead of keeping it in low-yielding bonds.

Owning BRK.B lets me sleep well. If there are companies offering above-average returns with less than average risk, then Berkshire Hathaway is such a company.

Disclosure: I am long BIP, BRK.B, OTCQX:BASFY, OTCPK:TSCDY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Criteria For Avoiding Risky Stocks: Learning From Berkshire Hathaway