Challenge conventional thinking on risk and invest smarter

By Paul Farah

How can I manage risk when investing? Can risk actually be controlled by an investor? And what are ways I can reduce risk in my investments? In this edition of Investing chronicles, Lockstep CEO Paul Farah tackles these questions with a fresh perspective and often overlooked strategy.*

I want to share my perspective on risk, which, while not unique, diverges from conventional thinking and is, more importantly, not intuitive.

What risk isn’t

In its purely theoretical form, risk is the volatility of a share price. The more a share price fluctuates, the riskier it is perceived to be.

I disagree with this concept!

Share price volatility is more a measure of emotional stimulus than risk – we become depressed and anxious when the share price moves significantly below our purchase price and exuberant when the share price rises above. But mood swings are not risk!

How I perceive risk

In investing, the risk is that we lose money; we lose money when we are forced to sell our investment at substantial losses.

Therefore, to better understand risk, we need to understand what it is we are trying to do so that we can reduce making big mistakes.

What is investing actually?

In its essence, investing is laying out cash today with the expectation of getting more back sometime in the future. We are, therefore, occupied with trying to answer three fundamental questions:

1. How much cash will I get back?
2. When will I get it back?
3. How certain am I of getting it back?

The better I can answer these questions, the greater the probability of a successful outcome and the less risk I have of losing money. But the opposite holds too in that:

LESS certainty = MORE risk.

Intrinsic value: What is it?

To answer the questions above let’s work an example together:

We are considering purchasing a company, The Once-ler Company, which manufactures Thneeds (borrowed from The Lorax 😉). We are fortunate to have a crystal ball to know that Thneeds will be in fashion for exactly 10 more years before no one buys one ever again. Furthermore, our crystal ball gives us perfect foresight regarding the company’s future cash generation:

Thanks to this foresight, we know that Once-ler will generate $1 000 in cash over its remaining lifespan. However, as cash received tomorrow is worth less than cash in hand today, we discount these future cash flows back to their present value – let’s use a 5% discount rate for simplicity:

So we now know that Once-ler will produce $1 000 in the future, equivalent to $803 in the bank today (based on our 5% discount assumption).

The $803 is the company’s intrinsic value and is what we are trying to calculate when we invest. If someone offered to sell you the business for $850, you would turn it down, knowing you would lose money, but if offered $750, you would happily buy it, knowing you would be earning a $53 profit.

Intrinsic value and the real world

Unfortunately, in reality, investing isn’t that simple. I don’t know what the cash flow of The Once-ler Company will be. I don’t know how long it will remain in business. I don’t know how competent management is or what the competition will do. I have to, therefore, estimate what I believe intrinsic value to be based on certain assumptions.

Of course, the more assumptions I have to make, the more my uncertainty increases, and we know from above: uncertainty = RISK.

Unfortunately, even if we do all our homework, there will still be much we don’t know.

So, how do I reduce risk?

Intrinsic value is not a number but a range

We can reduce our risk by increasing the expectations of the possible outcomes for intrinsic value.

Instead of trying to guess a single number and declare that The Once-ler Company is worth $803, we can look at our assumptions and apply best- and worst-case scenarios to our estimates.

The best-case scenario is when we factor everything runs perfectly, and the company is worth $850. The worst case is the opposite, and Once-ler experiences nothing but headwinds, producing only $750 worth of cash in present-value terms. So, instead of saying the company is worth $803, we estimate it to be worth anything from $750 to $850.

But we can reduce risk further still.

Risk and the margin of safety

Let’s delve into the concept of the margin of safety, a term often encountered in investment discussions. While I’ve touched upon it briefly in a previous newsletter, let’s explore it more deeply here.

Returning to The Once-ler Company – after all our hard work and analysis, we estimate it is worth between $750 and $850.

So, would I actually buy it for $750? Probably not, because what if my calculations are wrong (and they definitely will be no matter how good an analyst I am) and I have overstated the value? It might only be worth $700; I would have lost money.

But what happens if the market panics, for whatever reason, and someone is offering to sell me Once-ler for $500? I would now have a safety net if my calculations were wrong and the company only produced $700 or even $600 worth of cash.

The larger the safety net, the wider my margin of safety and the LOWER THE RISK.

(Companies can actually be offered at massively discounted prices; just look at when Meta Platforms (META) traded at under $100 per share because the market panicked.)

Risk and the share price

You might have noticed that in our discussion thus far, we have not mentioned the share price. That is because, if you agree with my concept of risk above, it has little to do with the company’s share price.

The share price is simply the price of the most recent transaction between the buyer and the seller of a share. It has nothing to do with what a company is worth – the seller believes the company is worth less, or they wouldn’t sell, and the buyer thinks it to be worth more. But just because they believe it doesn’t make it so.

But we know better and can take advantage of this!

We now know that a falling share price implies our margin of safety is increasing, and therefore our risk is REDUCING. Conversely, a rising share price means my risk is INCREASING because my margin of safety is diminishing.

Summary

My task as an investor is to figure out:

1. How much cash I expect to get back in the future;
2. When I expect to get it back; and
3. My level of confidence that it will happen.  

I cannot accurately calculate how much cash I will get back, so I estimate a range of the intrinsic value using differing scenarios.

To provide an additional safety net, I invest when the share price is lower than that range.

Therefore:

• When the share price retreats, my margin of safety increases, so my willingness to buy more shares increases.
• When the share price appreciates, my margin of safety diminishes, and I become more inclined to sell.

Hopefully that gives you a better understanding of risk, at least how I perceive it. And perhaps you even agree!

There’s plenty more to discover with Lockstep.

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* Paul Farah has worked in financial markets since 2006, holding positions at prestigious firms from New York to South Africa. Now, he manages his own money and provides access to his entire portfolio through his company Lockstep Investing. The views and opinions shared are his own and are for informational purposes only, it is not intended to serve as investment advice and it does not represent the view or opinion of Standard Bank. This information should be used as a starting point for generating investment ideas,and should not be relied upon as the sole basis for making investment decisions. Lockstep Investing (PTY) LTD and the Standard Bank of South Africa Limited will not be responsible for the results of any investment decisions made based on the views provided.