WHAT IS RISK

Conventional wisdom views volatility as risk. We don’t. We befriend it, embrace it, and try to take advantage of it. The true investment risk is not volatility but permanent loss of capital. For someone who has not researched a company, it is not readily apparent whether a decline in shares is temporary or permanent. After all, if you don’t know what the company is worth, the quoted price becomes the quotient of intrinsic value.

If you know what the company is worth, then change in intrinsic value is all that is going to matter. The price quoted on the exchange will be your friend, allowing you to take advantage of the difference between intrinsic value and quoted stock price. If the quoted stock price is significantly cheaper than your estimated intrinsic value, you buy it or buy more of it if you already own it. If the opposite is true, you sell it.

What is a company worth? Determining the intrinsic value is a combination of art and science (in that order) – it is not quoted on the exchanges. We go about this the same way a businessman would figure how much he’d want to pay for a gas station or McDonalds franchise.

Analysis of each company will be different, but at the core we estimate the cash flows the business will produce for shareholders in the long run (at least ten years), and what the business will be worth then (based on our estimate of its earnings power at the time). The combination of the two provides us an approximation of what the business is worth now. But this is just a start. Then we look at known risks and try to imagine unknown ones. We try to quantify their impact on cash flows – we try to kill the business.

This “killing” helps to us understand how much of a discount to what this business is worth we should demand. This discount is also called “margin of safety.” By applying this discount to fair value we arrive at a buy price. For every stock we buy we probably look at twenty and do very serious analysis of ten or fifteen. In this analysis, what happens this month, this quarter, or even this year is only important in the context of the long run. Unless the company’s good or bad earnings report in any quarter changes our assumptions of the company’s long-term cash flows, it is just noise, which is just another word for … volatility!

One significant but often unappreciated benefit of a separately managed account is that, unlike owning a mutual fund or ETF, you can see the stocks you own. A discussion of mutual funds or ETF performance is somewhat nebulous (we are generalizing) because it very quickly turns into a discussion about the market. But when you can see every stock in your portfolio, you don’t have to think about the market; you can look at each stock as partial ownership of a real business and discuss how this or that risk will impact it. When you own the market you are not sure how lower oil prices will hurt or benefit your portfolio, but when you own just a dozen stocks, this discussion becomes very straightforward.

We spend a significant amount of time trying to be as clear and transparent as we can about our thoughts on the market and individual stocks. Whenever clients get concerned about the market, they just call us. We will probably not be very helpful with the overall market discussion, but we’ll walk them through each stock in the portfolio and try to shed as much light as we can on what we believe each is worth.

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