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Weekend reading with James Montier: The trinity of risk

I am very happy to share with you the article that has been the base for my quick reviews: The trinity of risk by one of my favorites: James Montier


In this article argues that value investing is the “only investment approach […] that puts risk management at the heart of the process” and by this he means the risk of permanent loss of capital.


Re-shuffling the risks to mirror the order in which I look at them in my quick reviews, we have:


1-       Business risk: which using Graham’s quote is: “the danger of a loss of quality and earnings power through economic changes or deterioration in management”. In order to evaluate this risk and get a sense of strength and stability of companies, I review their cash generation, returns on equity and assets and growth. I also evaluate management’s shareholder orientation through a review of their uses of cash.


2-       Balance Sheet risk: Here Montier suggests using Altman’s z-score as a good measure of health. In my framework I may be a bit more stringent, usually requiring a Debt/Equity ratio below 1.0x.  If the company seems promising enough that I perform a longer analysis I also review Altman’s z-scores but given my requirements beforehand z-scores in my analyses have so far turned out to be good (over 3.0x)


3-       Valuation risk: using again a quote from Graham to introduce the idea: “The danger in… growth stock(s) [is that] for such favored issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings”.  Graham (and Montier) often used what is now called the “Graham and Dodd P/E” or the P/E using 10-year average earnings. Graham put a line in the sand in terms of maximum valuation he was willing to invest at: “We would suggest that about 16 times is as high a price as can be paid in an investment purchase of a common stock”.  In my quick reviews I look at both P/E (NYSE:TTM) and cash returns (enterprise value / Free cash flow) to get a sense for valuation.


What metrics do you use to evaluate companies along these and maybe other dimensions?


Have a great weekend!



Disclosure: No position