A friend of mine recently asked me: “How do you define risk when investing in stocks?” It’s a really good question that I think is worth fleshing out in an article.
In my opinion, there’s too much fuzzy thinking when the topic of risk in stocks pops up. It doesn’t help that the academic definition of risk in financial markets is simply price-volatility – I think this definition is wrong if you’re investing with a long time horizon.
Responding
Here’s my reply to my friend’s question:
“To me, risk is the chance of permanent or near-permanent loss of capital. And that risk can come in a few ways:
1) Confiscation by government
2) Damage from war and/or natural catastrophes
3) Inflation and deflation
4) Extreme overvaluation
5) Management fraud”
I missed out on one more source of risk-according-to-my-definition, and that is companies going bankrupt. (I will be sending this article to my friend so that he gets the complete picture!)
Volatility is not risk
I want to first discuss why I think price-volatility is not the same as risk if you’re a long-term investor.
In his book Deep Risk: How History Informs Portfolio Design, the polymath investor William Bernstein categorised investing-risks into two forms. Here’s the Wall Street Journal’s Jason Zweig describing the first form of risk in an article:
“What Mr. Bernstein calls “shallow risk” is a temporary drop in an asset’s market price; decades ago, the great investment analyst Benjamin Graham referred to such an interim decline as “quotational loss.”
Shallow risk is as inevitable as weather. You can’t invest in anything other than cash without being hit by sharp falls in price. Shallow doesn’t mean that the losses can’t cut deep or last long – only that they aren’t permanent.”
Shallow risk is the type of risk that time can erase. It’s not permanent. And if we’re long-term investors – and everyone should be long-term investors! – I believe we need not be concerned about shallow risk.
In presentations on the market outlook for 2020 that I gave in December 2019, I played a game with my audience:
“I’m going to share two stocks with you, and you’re going to tell me which you would prefer to invest in.
Stock ABC is the first. It was listed in 1997. From 1997 to 2018, the peak-to-trough decline in Stock ABC’s share price in each year had ranged from 12.6% to 83.0%. Put another way, Stock ABC had experienced a double-digit peak-to-trough decline every single year from 1997 to 2018.
Now let’s look at Stock DEF. It was also listed in 1997. And the chart shows Stock DEF’s share price growing by an astonishing 76,000% from $2 in 1997 to $1,500 in 2018. It’s obvious that Stock DEF has been an incredible long-term winner.
With this information, would you prefer to invest in Stock ABC or Stock DEF?”
I then revealed their identities:
“Here’s the kicker: They are the same stock. Stock ABC and Stock DEF are both Amazon, the US e-commerce giant.”
While building massive long-term wealth for its investors, Amazon’s stock had displayed shallow risk time and again.
I’ve owned Amazon’s shares since April 2014 and over the past five-plus years, I’ve experienced countless painful short-term falls – the peak-to-trough declines in Amazon’s stock price in 2016, 2017, and 2018 were more than 20% in each of those three years. But I was never worried. Amazon’s business was – and is – growing rapidly. From April 2014 to today, Amazon’s stock price is up by around 500%. The e-commerce giant’s shallow risk simply melted away with time and the growth of its business.
Permanent or near-permanent loss of capital
Zweig’s article also mentioned Bernstein’s second form of risk:
“Deep risk,” on the other hand, is an irretrievable loss of capital, meaning that after inflation you won’t recover for decades – if ever.”
Bernstein’s deep risk is the same as my definition of what risk really is when investing in stocks. According to Bernstein, four things cause deep risk:
- Inflation: A runaway increase in prices, which eats away the purchasing power of money.
- Deflation: A persistent drop in asset prices, which have been very rare occurrences throughout world history.
- Confiscation: When authorities seize assets, by onerous taxes or through sheer force.
- Devastation: Because of acts of war or anarchy (and I’ll add natural catastrophes to the mix too).
The sources of deep risk that Bernstein shared are the first three risk-factors that I mentioned in my answer to my friend’s question. My response also included my own sources of deep risk: Extreme overvaluation, management fraud, and company-bankruptcy.
Japan’s stock market is a classic case of extreme overvaluation. Today, the Nikkei 225 Index – a benchmark for Japanese stocks – is just below 24,000. That’s around 40% lower than the all-time high of nearly 39,000 that was reached in December 1989, more than 30 years ago.
At its peak, Japanese stocks had a CAPE ratio of more than 90, according to investor Mebane Faber. That’s an incredibly high valuation, which led to the Japanese stock market’s eventual collapse. The CAPE ratio – or cyclically-adjusted price-to-earnings ratio – is calculated by dividing a stock’s price with its average inflation-adjusted earnings over the past 10 years.
Management fraud involves cases such as Enron and Satyam in the US. Both companies saw their leaders fabricate financial and/or business numbers. When the shenanigans were exposed, both companies’ share prices effectively went to zero.
At home in Singapore’s stock market, there have been cases of fraud too. Some involve S-chips, which are Singapore-listed companies that are headquartered in China. An example is Eratat Lifestyle, a company that was supposedly manufacturing and distributing fashion and sports apparel.
In 2014, Eratat was discovered to have forged its bank statements. Instead of having RMB 577 million in the bank account of its main subsidiary at the end of 2013, as was claimed by the company, the account only had RMB 73,000 (that is 73 thousand) in cash.
Eratat made its final official filing with Singapore Exchange – our local stock exchange operator and regulator – in June 2017, more than three years after the trading of its shares was stopped in January 2014. The final official filing stated that Eratat was “hopelessly insolvent” and “there will not be any distribution available to the shareholders of the Company.” Investors in Eratat lost their shirts.
The downfall of Eratat
I want to digress a little here and share more about what happened with Eratat. There are great lessons for us to be found in the episode.
It turns out that there were two massive danger signs that appeared before all hell broke loose.
Firstly, there was the unusually low interest income earned by Eratat. In 2012, the company reported average cash holdings of around RMB 270 million. Yet it earned interest income of just RMB 1.4 million, which equated to an average interest rate of only 0.5%. RMB-denominated deposit rates in China were easily 3% during that period.
Secondly, Eratat issued bonds with absurdly high interest rates despite having plenty of cash on its balance sheet. In July 2013, Eratat issued bonds with a total value of RMB 100.5 million to Sun Hung Kai & Co., a Hong Kong-based finance company. The bonds had short tenure of merely two years (meaning they had to be repaid after two years), but came with an effective annual interest rate of 16.7%. Interestingly, Eratat reported having RMB 545 million in cash and zero debt on its balance sheet just prior to issuing the bonds. Of course, we now know that the cash that Eratat claimed to have was fictitious.
The next time you see a company earn a pittance in interest income on its cash holdings and/or borrow at ridiculously expensive rates despite appearing to have lots of cash, be wary. You should check if there are any good reasons behind such things happening.
Circling back
Company-bankruptcy is another way for us to suffer a permanent loss of capital. And we should note that bankruptcies can happen even with management teams who are not fraudulent. Sometimes it’s a simple case of a business running into trouble because of high debt and an inability to generate cash.
Hyflux is a good example. The water-treatment company filed for bankruptcy protection in May 2018 but prior to that, the company was already laden with debt and was burning cash for a number of years. There are questions surrounding the competency of Hyflux’s long-time leader, Olivia Lum, but Hyflux’s case is a business-failure, and its collapse had nothing to do with fraud.
Protecting ourselves
After running through the concepts of shallow risk and deep risk, you may be left wondering: How can I protect myself from deep risk? Zweig’s aforementioned article also offered suggestions from Bernstein, which I will summarise [my additional inputs are in square brackets]:
- Inflation: Globally diversified portfolio of stocks; [also look for companies with pricing power, so that they can pass on cost-increases to customers].
- Deflation: Long-term government bonds; [also look for companies with pricing power, so that they can keep their selling prices intact in a deflationary environment].
- Confiscation: Own foreign assets; [or invest in markets where the government has a strong history of respecting the rule of the law and shareholder rights].
- Devastation: Nothing much we can do! ¯\_(ツ)_/¯
For the sources of deep risk that I put forth:
- Extreme overvaluation: Pay attention to the valuation of the stocks we invest in.
- Management fraud: Be vigilant about unusual transactions that a company has made; and build a diversified investment portfolio so that even if we unfortunately end up with a fraud case, our portfolios will not be ruined.
- Bankruptcy: Invest in companies that are operating in industries with bright prospects and that have strong balance sheets and good ability to generate free cash flow.
Protecting ourselves from ourselves
The final few paragraphs of Zweig’s article on Bernstein’s thinking on risk is extremely noteworthy. They highlight the idea that our own behaviour is an important source of deep risk. Zweig wrote:
“Look back, honestly, at what you did in 2008 and 2009 when your stock portfolio lost half its value. Then ask how likely you are to hang on in a similar collapse. Your own behavior can turn shallow risk into deep risk in a heartbeat.”
I couldn’t agree more. Benjamin Graham once said that “The investor’s chief problem – and even his worst enemy – is likely to be himself.” Sometimes, we create our own headaches.
The CGM Focus Fund was the best-performing US stock mutual fund in the decade ended 30 November 2009 with an impressive annual return of 18.2%. But shockingly, its investors lost 11% per year over the same period. How did this tragedy happen?
It turns out that CGM Focus Fund’s investors would get greedy when it had a purple patch and pour money into it. But the moment the fund encountered temporary turbulence, its investors would flee because of fear. Shallow risk had turned into deep risk for CGM Focus Fund’s investors – all because they could not save themselves from themselves.
So when we’re thinking about risk when we’re investing, we should never forget the biggest source of deep risk: Our own behaviour.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.