Risk is a mosaic, not a formula

By Morningstar |  28-09-20 | 
 

Rupal Bhansali, chief investment officer and portfolio manager of Ariel's international- and global-equity strategies, engaged in a long conversation with Morningstar’s Jeff Ptak and Christine Benz last year in Chicago.

Her holistic views on risk were extremely insightful and have been extracted from that conversation.

  • For data-point investors, the past becomes a prologue for the future.
  • Be aware of companies where the business is fundamentally changing.
  • Look for changes in the business which have not yet started to manifest itself in the numbers.

As fundamental investors, we are driven by forward-looking assessment of business and risks. We focus on inflection points, not data points. Inflection points tell us if the future going to look different from the past, and whether that is an opportunity to arbitrage, either by avoiding or owning it.

Historically, a lot of people think that Consumer Staples is high-quality, low risk, and a safe defensive quality sector. We did not own Macy's or Sears. Gillette had pricing power till it didn't. In fact, Harry's has taken a lot of market share, thanks to the arrival of Instagram and social-media strategies. A couple of years ago, for the first time in the history of Gillette, the company lowered prices on its blades as opposed to raise them. This is an example of how historical data-point investing thinking that “this is safe and that is risky”, is a misnomer.

Markets are very dynamic. Markets evolve. If history was always going to be the prologue to the future, then we could all be just reversion-to-mean investors. And we know that does not work in markets.

Business models are fundamentally changing. Look at Kraft Heinz. There was a business-model risk that manifested itself in financial leverage risk that is now manifesting itself in stock valuation risk. They are unable to generate enough revenues or cut their E&P costs. Once your product does not appeal to the consumer, it is going to show up in the numbers, and eventually, the stock price.

A similar thing is playing out in Apple. Apple's flagship product, iPhone X did not sell well. And yet, people are used to looking at Apple from the lens of yesteryears, and thinking of it as a technology company, with its ecosystem, et cetera. Well, once your flagship product starts to disappoint, your entire ecosystem has a challenge, because services revenue, which is what people are pinning their hopes on, is a function of the installed base. If your installed base is shrinking – well, look at Yahoo.

A lot of people argue with me and say, “I'm not going to give up my iPhone”. I'm not asking you to. But if a consumer electronics company like Apple does not sell a new piece of hardware, there is no revenue booked. All that has to happen is the replacement cycle of an iPhone has to extend itself from, say, 2 years to 3 years and that's a third less in revenues. That's not a stretch at all.

People think of Apple as a low-risk, high-quality business model. We would argue the opposite. There is a very high amount of business disruption risk for that company, partly because of this lawsuit that's now coming up where Spotify and others are suing the company for acting monopolistic in terms of the distribution platform that it offers, and the pricing that it charges for it. And it's got competitive risks, because the competitive profile, the specs of the iPhone are not as competitive vis-à-vis the Samsung Galaxy, vis-à-vis Xiaomi's phones, and other phones in the Chinese market, which is a big source of incremental growth for them, and they are priced a premium without having premium specifications that compete effectively.

That was exactly the setup for a Nokia back in the day. That was exactly the setup for a Blackberry back in the day. We were all addicted to these things. We could imagine a future without a Blackberry. As time has passed, we saw consumer electronics companies tend to be a hit or miss. Apple is a consumer electronics company. It is not a software company as people would like to believe.

Microsoft is a software company. We cannot do without Outlook and Excel and PowerPoint and Word. And every month we are going to pay a subscription revenue for it.

All tech companies are NOT the same, and the market needs to figure out where is the risk and where is the reward.

  • Investing has become far more sophisticated, far more global in nature.
  • Competitive advantage in every sector is not concentrated in one geographical market.
  • Good ideas don’t have borders.

If I wanted to own a tyre company and I restricted myself to the U.S., I would be forced to own Goodyear, which is not a very idiosyncratically good name to own. Its manufacturing process is not well evolved. They have not invested in technology and R&D and training their workers, which is why they are having difficulty in ramping to the higher rim-size models of tires, which are now more prevalent as more and more people buy SUVs, and premium cars, which have bigger rim size tires compared to passenger cars, which are the traditional 16-inch tire market, which has commoditized and that's not where the money is. Not only does it have manufacturing issues, it has balance-sheet issues. It is an extremely leveraged company.

The best tyre companies are Michelin (France) and Bridgestone (Japan).

Japan was the first country in the world to do QE. We knew that this would really badly affect the banking sector. Japanese banks have never really reclaimed their former glory. That's exactly the playbook that is playing out in Europe.

Value investing at the core is about having a margin of safety. It's about intrinsic value, always trying to understand what you're getting, not just what you're paying. And if what you're getting in the banking sector was a lot of risk, what you paid for it should also fall. We are completely and utterly underweight banks, which traditionally is a sector that value investors were overweight. That's because its intrinsic value is fundamentally compromised. In Europe, which is seeing negative interest rates, it is extremely hard for a bank to make money, and then they have to incur costs and pay bills and fines and litigation risks, and the underwriting cycle is going to turn against them, because now the macroeconomic slowdown is sort of beginning to appear in full force.

So if you look at investing from a very narrow universe with no macro awareness, it's extremely hard to connect the dots.

  • Risk and Reward is what drives portfolio construction and outcomes.
  • It must not be only about returns, but risk-adjusted returns. Don’t focus only on what can go right, ask what can go wrong.
  • All investment theses stand on their own merits from a risk and reward standpoint.

It is managing of risk and return, not just returns, which is why we pay attention to both simultaneously. That means, we will own stocks that may not have a lot of returns but have very limited risk.

So, a good example of that is Berkshire Hathaway, which may not have the same upside potential as, say, Michelin. But Berkshire also has less downside risks potentially. The thesis underpinning Berkshire Hathaway and the business model of Berkshire Hathaway and the underlying drivers of what's going to cause that business to perform is completely different from Michelin, a tyre company.

It is important to get your thesis right. Because in a portfolio there are always theses that develop at different points in time. So, when one is not working, the other is, and you get that diversification benefit just from that standpoint.

For the good news to play out, it can take a couple of quarters or a couple of years. We care about more if our thesis will play out, not when they will play out.

In 2012, we bought Japan when nobody wanted to touch it as it was a proverbial submerging market. In the next few years, Japan was one of the best-performing markets in the world.

Our negative view on emerging markets took almost 5 or 6 years to play out. We were very underweight emerging markets when it was a default overweight in the portfolios. But whenever people over-index on one variable, they ignore another - the downside risks. Currency risks, political risk, balance-sheet risk was simply not being priced into the stocks. And EMs as an asset class has completely disappointed.

I remember the TMT (technology, media, telecom) where growth and momentum was very much in favour. The stocks that were the riskiest were the ones that were performing the best.

In 2006, we started selling our banking stocks. And we had a spectacular performance in 2008 when a lot of investors lost their shirt. Unlike a growth manager who kept admiring the growth rates of banking when they were growing like weeds or a value investor who typically loves banks because they trade at low multiples, we did neither. Banks were taking on too much risk. And we pay attention to risk.

Risk management is like an insurance policy. You can't suddenly think of buying fire insurance when the house is already burned down. Attempt to identify proactively all the risks that you could get exposed to. And if they are overwhelming and large, walk away.

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