This last summer i decided to teach my sons to play the Spanish card game Mus. The funniest part was to witness their reactions as they got good and bad hands. One of the first hints they needed was to “lose little when you lose, to be able to hold on until good cards come”. Bluffing isn´t a sustainble strategy, no matter how satisfying it may be to steal the hand! To thrive, one needs to survive first. As the great Kenny Rogers song said…”you have to know when to hold them, know when to fold them, know when to walk away and know when to run…”.
Survival, capital preservation, is also the key to win “the market game”. My epiphany on this came during the 2008/09 market meldown. The broad markets – USA, Europe, Emerging… – fell by -50% or more until the lows of 2009. The subsequent recovery until the end of that same year was around +60%. Therefore, for an operator who preserved his capital the recovery would have been +60%, or perhaps more if he picked the right spots. However for someone who didn´t preserve his capital the effective recovery was…+30% only as he only had half the capital left to work for him. In this way, like others with free mandates that allowed them to protect their capital, I suddenly found myself rising twice as fast as the market.
In 2008 the collapse was generalized and very much driven by liquidity needs: losses in investment A required liquidity and therefore investment B was fire-sold to supply it, causing losses to B. Then losses in B required liquidity and forced sales of C, and so on. In many occasions the share price collapses had little or nothing to do with the fundamental solidity of specific businesses and companies. That was proved right over the recovery that ensued the following years. But the key point to participate in that recovery was to remain alive…That is why risk management is so critical – it preserves capital and enables investors to fully take advantage of market irrationality.
Risk management is the flip of the coin to performance in asset management. And it is a continuous exercise of humility on many levels. That is what is behind correct investment horizon, margin of safety, business and sector follow up, diversification, relative position weights and sale or mistakes.
Firstly, in Cobas we always talk about making sure that one can wait and avoid the investment of liquidity that could be needed in the short term. This is because even if we assume our investment thesis to be correct, we really have no idea about when it may materialize – one month, one year, or perhaps later. Thus we give ourselves some margin for error. We also tell ourselves that if the thesis hasn´t worked in 3-5 years…perhaps we are wrong. Anyway, risk management at this level involves the managers of the funds, but also their investors.
Next comes margin of safety, which implies an exercise of humility on two levels. First because we only decide to make investments with enough upside potential (and only if we can understand them well). In this way even if we are making a mistake we still preserve our capital. For example if we invest 100 in a business which we think is worth 200, and we are wrong by 50%, we can still recover our initial investment – our only loss will have been opportunity cost. Secondly on margin of safety, we base our valuation on conservative assumptions. This is why we favor solid and established businesses and we humbly avoid the more complex field of new trends and hypercharged growth where things change so fast and anything can happen. We leave that to other braver investors.
Thirdly, it is important to explain that even though the initial valuation needs to be very thorough, the follow up on the business and the management team needs to be every bit as intense. This is the vital phase to track progress of or mistakes in the original thesis, to be able to act in a timely manner. Unfortunately one needs to admit that investment theses are never “master pieces” which are complete which one can be proud of. On the contrary we need to spend at least 75% of our time on intense and continuous follow up of the ideas in our portfolio. Investing is a full time job for this reason.
Fourthly, diversification, is just about common sense – not hoarding all eggs in the same basket. Active investment seeks the balance between large enough positions so that their impact can be material and greater than passive investment, but also diverse enough so that in case of mistakes capital is still preserved. Once again, even when one is fully convinced of the robustness of the business and the valuation based on conservative assumptions, when one really trusts management and there are valuable assets in the balance sheet…still anything can happen. We hope for the best but prepare for the worst. Diversification will mean investment weights will evolve as the relative attractiveness of our investments changes over time due to share price moves and as our follow up work feeds back new information. We strive to adapt our stance towards those names with the better return/risk combination.
Finally, the sale of failed investments, errors, is the greatest test to humility. An error is an investment thesis which is unlikely to come true and where we will not make money, or worse still, where the risk of losing it has become too large to bear. The key is really that the investment process remains solid, so that we can be right many times and wrong few times. But emotionally it is very painful to be wrong and we all interpret that as a “bad job”, even if the process was right. This is why human nature builds all these barriers and biases such as loss aversion, confirmation bias, representativeness, familiarity bias and so many others. Also, even after a mistake we need to be able to re-set and see each investment for what it is today – perhaps a past mistake offers a great investment today. Or perhaps not. We need the character to keep emotion out of it. There is no fleeing forward in the market, and bluffing doesn´t work either. Only detailed work and character – resilience, humility and patience – can help us.
Therefore risk management is part of the investment process. It is much more difficult to appreciate than the simple daily/monthly/annual performance numbers. But in my view it is a lot more important – anyone can make 100% return in a casino roulette…but was that pure luck (all on red) or repeatable skill? This is the reason why institutional due diligence processes focus their efforts on understanding and checking the investment process of asset managers before they give them a mandate. Meanwhile time is unforgiving in its due diligence too and weeds out bad risk management. Only those good at it survive to tell the tale.
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