An investment is defined in the Webster dictionary as the following: To commit (money) in order to earn a financial return. Beta is defined as a measure of the risk potential of a stock or an investment portfolio expressed as a ratio of the stock's or portfolio's volatility to the volatility of the market as a whole. These definitions do not correlate, rather one should treat "beta" as a speculative term and should strive to understand the true meaning of investment risk. The focus of this article describes the true risk an investor experiences and recent examples underlying the importance of having a margin of safety with a long term mind frame.
Speculating has always been a part of Wall Street and Las Vegas; however, nothing about speculating has to do with investing. A speculator is considered throughout the mainstream media and business outlets as part of being a typical investor. This simply is not true as an investor seeks financial gain through disciplined, unemotional, and intelligent decisions. The growth of one's capital through capital appreciation and compounded interest in financial securities understands true risk vs. Wall Street's and Academia's speculative term for risk known as beta.
In investing, an ample amount of safety between the values of a security one decides upon and the price paid for that value is premium to any speculative idea. Usually, this mind frame results in superior gains as well. Rather than relying on beta to determine risk, an investor throughout their career will realize the importance of stringent hard work in making investment decisions. If they are wrong, they lose money. Thus, it is imperative to have a strong understanding of a particular companies' fundamental position and prospects.
Risk in Growth Investments
A brief history of Wall Street will reflect how the more things change, the more they stay the same. Searching for companies that are worth $1 today that will be worth $2 tomorrow is not a leading philosophy on Wall Street. Although value investing has been separated from growth investing, there is a mix and requirement to understand both principals for an ample investment. One can take a couple of examples of both types and understand the basic principles of risks faced by investors making profitable investments in common stocks.
- Company A: EPS: $2 P/E: 20 Market Value: $40 a share
- Company B: EPS: $2 P/E: 20 Market Value: $40 a share
Both companies have the same earnings per share and price to earnings ratio of 20. This price to earnings ratio is high and accounts for excellent growth prospects, excellent management, and a top tier industry for the next 5 years. Thus, at the end of the 5 years both companies will double their earnings; however, what happens next is a fairly common occurrence when paying too high of a price for growth companies.
- Company A: EPS: $4 P/E: 20 Market Value: $80 a share
- Company B: EPS: $4 P/E: 10 Market Value: $40 a share
Company A has retained excellent growth prospects in a thriving industry and is rewarded by the market with a continued high P/E ratio of 20. This in turn reflects the doubling of its share price in 5 years with considerable optimism for continued financial success. Meanwhile, Company B has dimmer prospects for the next 5 years and in a struggling industry. Thus, the market has given it a P/E ratio of 10. Although the company has doubled their earnings, they retain the same market value as five years before. Although one theoretically didn't lose money on their investment, one has lost future purchasing power due to interest rates or inflation. This illustrates the true risk of paying too much for a "growth" company and how an ample margin of safety should be sought after when dealing with growth stocks to prevent this occurrence.
Value Investment Risk
True value investments start by searching for an underlying business where the market price is severally depressed and does not reflect the strengths and earnings power of that business. In this scenario, the company is undergoing several unfavorable events within the company or industry in which the share price declines significantly. Most commonly, these companies have lower P/E ratios stated below 9. Although there a lot of companies with "cheap" prices as declared by the media outlets and other speculators, one has to judge the fundamental strengths and future earnings power of a company relative to its current market price. If one is to believe the company is going to survive its current circumstances and the margin of safety of the investment is about 30% below an estimated range of its intrinsic value, then one should consider it a suitable and profitable investment in the long term.
There are some risks with this style of investing as well. It may take years to unlock their true value and may often experience greater declines in share price before the market creates a more favorable opinion of the company. In other instances, there are quick rebounds in the market price of that particular security. One should invest before they occur in order to be rewarded for their due-diligence rather than wait to be proved correct and miss the turnaround. Most recently, the technology and financial sectors have proven this since October of 2011 into early this year. However, investing is always clearer in hindsight 20:20 and one should learn and gain valuable knowledge from these recent events. The stock market will continue to offer great opportunities to have superior returns relative to the overall market.
Cisco (CSCO) and Intel (INTC) were examples from the technology sector in which I found extremely convincing valuations where a higher earnings per share and price to earnings multiple over the next 5+ years were probably going to exist. Cisco was being blamed for a loss of market share to Juniper (JNPR) and (HPQ) and a stagnant or decline of earnings and revenue growth. Both of these critiques of Cisco proved to be unfounded results. Intel was being given an unfairly low multiple despite +20% revenue increases that ended up increasing revenue over $20 billion in two years. This low multiple was given due to the presence of tablet hype and a lack of a mobile business at the time while ignoring their thriving PC and data center plus server business. Obviously, if one can dive deep within an industry and find out it has better prospects than the views expressed by the overall market, one has a substantial amount to gain if proved correct.
Along these lines, the financial sector included several undervalued companies at different price points during 2011. Bank of America (BAC) was virtually untouched at $5 a share, which priced Bank of America's underlying business two thirds below their tangible book value. Wells Fargo (WFC) and JP Morgan (JPM) were among some of the financials hit hard by the mortgage crisis and European crisis. These events offered compelling points of entry where their book value was slightly above their market prices at various times in 2011 as well. While a lot of ratios determine the market price of banks, a superior management team and prudent loans will lead to a very profitable bank.
Understanding Why Investment Risk is Superior to Beta Risk
The essence of these valuations requires talent and a lot of work to have rewarding gains. The risk in dealing with unwanted or unattractive securities is that it may take time for the market to readjust their view on the security or industry. During this time, drastic declines may occur. Thus, one should then check their fundamental analysis and own personal, unemotional instinct to have the courage to buy more shares at a cheaper price. Taken together, when an investor looks for opportunities to invest there should be ample room for error, which also tends to create superior market gains in the long term. If you are wrong, you lose money. It's key in investing not to lose money, as you lose capital and the fundamental strength of capital being compounded throughout your investment career. When an investor understands the probability of events likely to occur that will affect their investment and knowing the unknowns of investing, they create themselves a margin of safety that eliminates unnecessary and speculative risks. On the flip side of this risk, one is rewarded for understanding a situation that will probably come out better than expected with superior market gains in those selected securities.
As for using "beta" for risk, one can assume that they are better off owning Bank of America at either $5 or $10 a share because the risk is the same. The reason is that volatility is tied to the overall market's volatility rather than the company's' share price. In essence, one is using a statistical concept tied to macroeconomic and political themes rather than the important fundamentals of the company. These include, but are not limited to, the qualitative and quantitative facts of the company, the industry in which they compete, and their competitors as well.
The true risk of an investment is not a statistical concept of any sort. It is the risk of being wrong on your investment decision by paying too high of a price based on speculative traits and information. Rather, one will find superior gains and margins of safety with a strong fundamental background and competence of a company that one believes is valued 30% below their estimated intrinsic value-range of that company.