Managing Risk To Help Achieve Long-Term Goals

by: Chowder

Summary

Deciding which risks to embrace and which to ignore.

Quality wins in the long run.

How much do you need, when do you need it, and how sure are you that it will be there at that time?

There are many definitions of risk and there are as many ways to plan for it. A basic definition of risk refers to the chance that one will be exposed to danger, harm, loss, or things not turning out as hoped for expected.

In my opinion, with the number of various risks out there, it would be very difficult to design a successful portfolio that could cover them all. In my opinion, risk needs to be prioritized.

I decided I would break down risk into three categories, based on what I think is more important to me, and ignore the rest. My thinking is that if I can manage the Big Three, quality and time will take care of the other risks that we face in investing.

Most people define risk as share price volatility. That risk doesn't even show up on my radar unless I am trading or speculating. Stocks fluctuate in price. If you want the long term gains that stocks can provide, you've got to pay the toll. The toll is price fluctuations.

I know some are nodding and saying yeah, you've got to do more than know it intellectually, you've got to embrace it. If you don't, your investment strategy is going to fall apart, done in by bad decisions, inadequate returns, and all caused by emotional insecurity.

There is nothing wrong with price fluctuations with an investment that is considered best in breed in an industry, but the intolerance of price fluctuations has caused many overly cautious investors to pass up wonderful opportunities.

I don't understand how people can pass up on high quality companies (companies rated BBB+ or better by Morning Star and S&P Capital IQ), for lower quality companies, in favorable market conditions, under the guise that high quality companies are fairly valued or above fair value. I will look for value obviously, but I'd rather pay up for quality than buy low quality at a better price. If share price pulls back and your high quality companies don't bounce back, nothing is going to bounce back.

A low quality company (junk rated), may rise in a bull market but when the market pulls back they'll probably draw down significantly more than the high quality companies due to weaker earnings performance, which is one of the reasons why they are probably low quality companies to begin with.

Let's look at energy. Oil prices started falling in August. Companies came out lowering earnings expectations. There's the flag the market was waving for you to monitor your energy holdings. The market, and the companies themselves were telling us to sell our more risky, lower quality companies because when "risk off" comes into play, these companies take the biggest hits.

Other companies -- the more financially sound ones -- don't pull back as much. Institutional Investors will hold on to quality, but sell junk rated businesses lickity-split.

Exxon-Mobile (NYSE:XOM) for example is 16.1% below it's recent 52 week high. The energy sector is going through a bust cycle at this time and for a company to draw-down just 16% is rather bullish when you compare it to other companies in the industry.

Chevron (NYSE:CVX) is down a little more than XOM. Their draw-down to date is 22.8%. Both companies are financially sound but XOM has the more positive short term outlook over CVX when you look into what's going on in the business, and that's what monitoring is all about.

CVX has spent more on a per-barrel basis than its peers to get their LNG fields online. This spending, which should help CVX several years from now, has a short-term impact on earnings and the draw-down reflects that.

When one looks at the pipeline companies, the differences between high quality and junk couldn't be more pronounced. These companies are facing the same market adversities but check out the performance.

Linn Energy (LINE) is rated BB-. This is a very low quality company -- a company whose distribution/dividend is at risk of being cut or suspended. They can issue some preferred stock or go further into debt to keep paying the dividend, but at what cost?

LINE is already down 65.4% from its peak. And the bust cycle hasn't even really dug in yet.

Enterprise Products Partners (NYSE:EPD) on the other hand is rated BBB+ and is a more financially sound company. Even though they're in the same industry as LINE, they are only down 17.5% from a recent high. When you compare this with LINE, it's incredible. But, that's how quality works.

Now, Kinder Morgan, Inc. (NYSE:KMI) has a BBB- rating which would disqualify it for purchase in my portfolio, yet KMI is my largest position, and will remain so.

I believe the S&P rating is skewed due to the merger of KMP, KMR and El Paso Pipeline Partners. I believe the rating is temporary and the market agrees with me.

KMI is down only 7.6% from its recent high, and most importantly, the merger and current price is being supported by institutional investors. There is no way institutional investors are going to hold a company that just went through a major merger if they thought the company's credit rating was lowered in a "risk off" market environment.

KMI has a 4.4% yield and is expected to grow its dividend 10% per year for the next 5 years. When you add institutional investor support to those numbers, that's exactly the kind of company I want to over-weight in my portfolio, and I have done so. This company, in the face of deteriorating market conditions that have taken their toll on the share price of competitors, is holding up quite well. That's a sign of strength, and I buy strength.

If one develops the correct perspective, one can learn to appreciate investments that fluctuate. When you deal with quality, time is your ally. Quality companies will bail you out of a poor entry position if you give them the time to do so. It's all about the quality.

When I purchase a company, I fully expect that the company will establish a new all-time high somewhere down the road. It may be two years out, three years out, five years out, but it will be somewhere. After all, we're talking best in breed.

If I fully expect higher prices two to five years out, why should I be so fearful of a price pullback in the next month or so? It's crazy thinking.

It has been said that Warren Buffett's number-one rule is to not lose money. He is also on record as saying don't buy a company you'd feel uncomfortable holding if it suffered a drawdown of 50%.

So which is it? How do you experience a 50% drawdown in share price and not lose money?

I believe he's talking about owning and holding high quality companies. These are the companies that have shown they can overcome this type of adversity. These are the companies where you can ignore share price declines as long as the company fundamentals of doing business are intact.

Now this is important.

If you choose investments that are "investment grade," as determined by their financial credit ratings, the issue of losing your money forever isn't really the right understanding of risk.

The best long term investment is going to be one where you have the fullest faith and confidence that it will fluctuate back up after it fluctuates down, knowing it will be more valuable over time.

I believe that risk takes two very basic forms and everything else is an offshoot of those basic forms of risk. They are referred to as "Shallow Risk" and "Deep Risk."

Earlier this year, I read an article in the Wall Street Journal by Jason Zweig, where he wrote about these basic forms of risk. According to Zweig, William Bernstein, an investment manager at Efficient Frontier Advisors, calls "Shallow Risk" a temporary drop in an asset's market price. Key word being "temporary." Benjamin Graham, author of The "Intelligent Investor", referred to a temporary loss as "quotational loss."

"Shallow Risk" is as inevitable as the weather. You can't invest in anything other than cash without being hit by a sharp fall in price at some point. "Shallow" doesn't mean that the losses can't cut deep or last long -- only that they aren't permanent.

"Deep Risk" on the other hand is a loss of capital that you won't recover for decades, if ever. The four causes of deep risk are inflation, deflation, confiscation and devastation. These forces can make assets lose most of their value and never recover.

Bernstein says that we should insure against deep risks based both on how likely and how severe they are. For example, if you live in a flood zone, you should insure against flood before anything else.

As you break down the causes of deep risk, devastation would include war or anarchy. There isn't much that you can do about it. As far as I'm concerned, it is a risk I can ignore, other than not investing in countries with unsteady regimes or no law and order.

Confiscation can be attributed to a surge in taxation, or a seizure by government as happened to bank deposits in Cyprus.

For the most part, we can manage our assets for most taxes, but we must be aware that tax changes involve deep risk. A change to the tax laws regarding REIT's and MLP's would be a good example. So, we may want to keep those positions in proper perspective within our portfolios.

Deflation is the persistent drop in the value of assets and is very rare in modern history. It has hit Japan, but almost nowhere else in the past century, due to central banks that print money to drive up prices.

If one is concerned about deflation though, the best place to put your money would be in long-term government bonds. You could also get foreign exposure via equities since deflation isn't likely to hit all nations at once.

However, since bonds protect you from deflation, they expose you to inflation which is by far the likeliest source of deep risk.

Bernstein said that inflation can destroy at least 80% of the purchasing power of a bond portfolio over periods as long as 40 years. That is deep risk at its deepest. In my opinion, dividend growth is the best hedge against inflation. This does of course expose you to shallow risk, and shallow risk is something I have learned to embrace.

Investing in low quality companies for income exposes investors to deep risk. Owners of SeaDrill Ltd. (NYSE:SDRL) who enjoyed a very handsome dividend no longer receive those dividends. That income is lost, and with that the share price lost 74.5% of its value from its highs just a little over a year ago. That lost income can not be recovered by investing what is left over. Deep risk at its deepest.

People tell me how fortunate I was to have purchased so many companies in late 2008 and early 2009 because prices have risen so much since then. Everything I bought at the time saw an immediate drop in share price -- everything. It wasn't easy buying and holding at the time. And, I was 100% invested. I made the decision if the best in breed didn't come back, nothing was coming back. It was the right strategy to use.

So this brings me to the three biggest risks that I focus on.

1. How much money do you need, when do you need it, and how sure are you that it will be there?

Does it get any more basic than that?

The first two criteria are easy. I know what I need and I know when I need it. How sure are you that it will be there? That's the crux of a successful business plan.

Therefore, I define risk as the possibility of suffering a long term realized loss of capital, an unexpected decrease in the income flow, or not having the stated income flow at the time it is needed.

If you want to be sure that the money will be there when you need it, then that brings us to the second risk.

2. Company specific risk.

In my opinion, if one is to enjoy "long term" success, then the safest way to accomplish that is by owning the best of the best.

The very first thing I look at in the due diligence process is the company's financial safety rating -- their credit score if you will. If a company isn't investment grade, I go no further in my due diligence. This to me, is common sense investing.

If you were to buy a company outright, wouldn't you have the CPAs inspect the books? Wouldn't you want to know if the company were profitable or not? Wouldn't you want to know if the business was sustainable? Wouldn't you want to know the company's earnings potential?

Why should it be any different when we invest in equities? We are purchasing ownership in an ongoing business. Shouldn't we be just as concerned about that as we would be if we bought the company outright? I see people all the time chasing yield as opposed to buying financially sound companies.

Take LINE for example. It has a credit rating of BB- by S&P. According to Jefferson Research, LINE has a rating of WEAK when it comes to Earnings Quality. Other ratings; Cash Flow Quality - WEAKEST. Operating Efficiency - WEAKEST. Balance Sheet - WEAKEST.

Would one consider this quality? Is this considered as being financially sound? I don't get it unless people are simply chasing yield or speculating. It certainly doesn't satisfy the criteria of what most would consider a long term quality company.

Those ratings for LINE indicate the distribution is at risk, and for our purposes in this article, it's considered deep risk.

How sure are you that the money you need will be there when you need it, if you invest in companies like these?

It's all about quality.

This brings me to my third and last risk concern.

3. Safety of the dividend.

I realize that as a dividend growth investor, the focus should always be on the dividend growth. However, there are times when market conditions will go against you and some companies must freeze the dividend. One of the tactics I use is to determine a company's history with regard to whether they have cut the dividend in the past or not.

Here is what I am looking for. If push comes to shove, what is the worst I can expect? You measure what you might gain by what you might lose. Anyone who has suffered from dividend cuts has experienced significant capital depreciation.

I look to see if declining dividend growth is a prelude to a dividend freeze and then I look to see if a dividend freeze was a prelude to a dividend cut. It may not work with all companies, but whatever information I can muster helps me make better decisions towards my goal.

I mostly prefer to monitor the quality of earnings and cash flows.

In looking at EPD for example, Earnings Quality - STRONG. Cash Flow Quality - STRONGEST. Operating Efficiency - STRONG. Balance Sheet - WEAK.

With oil prices dropping, I would expect their accounts receivable and the number of days inventory is held would expand. Therefore with these metrics turning negative they in effect hurt the balance sheet. However, EPD has the financial strength to weather an oil bust cycle, and any drawdown in price, so I consider this to be shallow risk.

Conclusion

Part of the "price" one has to pay in order to achieve long term investment success is that they need to learn to tolerate price fluctuations.

Dealing with price fluctuations can be simplified by purchasing high quality, financially sound companies, that have shown a history of surviving and then thriving in the face of adversity. Your lack of emotion in relation to your investments and the daily swings in price will make all of the difference between good and bad decisions.

If you should purchase a company and the market reverses shortly after, keep in mind that if you are looking long term, quality companies will bail you out over time. They will bounce back. That's part of what makes them quality. Meanwhile, you'll get paid while you wait and what more could you ask for?

In the end: how much money do you need, when do you need it, and how sure are you that it will be there?

Disclosure: The author is long XOM, CVX, KMI, EPD.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.