I caught an interesting interview [1] with asset stripper / investor Wilbur Ross the other day.
For the unacceptable face of capitalism, Ross made a pretty good show of it. For a start, he revealed his childhood ambition was to be a creative writer. So was mine!
More importantly, in his telling, Ross’ key move to restructure the US steel industry was on the side of the unions and against ineffectual management. He made billions saving the rust belt from itself.
But I was most struck by a comment he made about investing in bankrupt steel company LTV in 2001, for which he was initially pilloried.
Far from being the crazy risk taker his critics suggested, Ross said:
We’re in the business not so much of being contrarians deliberately, but rather we like to take perceived risk instead of actual risk.
What I mean by that is that you get paid for taking a risk that people think is risky, you don’t particularly get paid for taking actual risk.
So what we had done we analysed the bid we made, we paid the money partly for fixed assets, we basically spent $90 million for assets on which LTV had spent $2.5 billion in the prior 5 years, and our assessment of the values was that if worst came to worst we could knock it down and sell it to the Chinese.
Then we also bought accounts receivable and inventory for 50c on the dollar. So between those combination of things, we frankly felt we had no risk.
That’s the sort of value investing approach that made Ben Graham [2], Walter Schloss [3], and Warren Buffett [4] their fortunes.
And while telling perceived risk from actual risk is far from the cakewalk that Ross implies, it’s a vital concept to understand – whether to give you faith to invest against the crowd [5], or for anyone silly enough to indulge in picking stocks.
Risk junkies or sober investors?
Let’s highlight that key quote from Wilbur Ross on risk:
You get paid for taking a risk that people think is risky, you don’t particularly get paid for taking actual risk.
The first thing to say is this is a very different concept from the risk of efficient market economists. When they say ‘risk’, they mean what I’d call volatility [6].
More specifically, according to the efficient market hypothesis [7], risk, reward [8] and volatility are all part of the same cat’s cradle – you can’t get one without taking on the other.
Remember: most economists don’t believe it’s possible to say one share is cheaper than another. To get higher rewards, you can only blindly put your money into riskier (that is, more volatile) assets.
To which Warren Buffett might reply: Never mind the theory, feel the size of my bank account.
Value investors like Buffett and Ross (or growth investors [9], or indeed any kind of non-passive trader) believe they can identify situations where they are paying 50p to buy £1 worth of company.
They call this the ‘margin of safety’, and say that it reduces the risks they take – because they are buying more cut-price assets – while increasing the reward – because they can eventually sell those assets for higher prices.
Where do such opportunities come from?
You might ask why anyone would sell a share worth £1 for 50p?
This brings us back to Ross’ concept of perceived risk. A value investor could argue that perceived risk is higher than actual risk because of:
- Oversight – An investor may identify company assets he believes the market has overlooked, allowing him to ascribe a value of say £1 on a 50p share.
- Underrating – The share may be trading correctly on its current prospects, but the market may have overlooked its medium to long-term potential. Think of Buffett’s investment in Coca-Cola, or more recently Burlington Rail.
- Fear – The biggie. When the market is fearful, most share prices are indiscriminately slashed. If you correctly judge that the fear is overdone, picking up bargain shares in a bear market [10] is like hitting three gold bars on a fruit machine.
Don’t try this at home
Sounds easy, doesn’t it? Unfortunately it’s not [11].
Most people fail to beat the market when they try stock picking. It’s a scientific fact. Review the psychological quirks [12] that can make you think you’re better at it than you really are.
In my view buying more shares when times look bleak and rebalancing your portfolio [13] towards safer investments when everyone is bullish is a bit safer.
That’s the classic Ben Graham approach of varying your stock allocation between 25% to 75% depending on how cheap the market looks, and it’s a good one because you never sell out completely – and so should avoid your dodgy market calls losing you a lot of money.
That’s important, because again most people are bad at such market timing. Private investors tend to put most money into the markets around their highs, and pull out their cash in the lows. And all this churn costs fees and taxes, which is a net loss from private investors to the finance industry.
As ever, you’ll probably be better off just passive investing [14] through the highs and lows of the market.
Hindsight is the best investor
Being a stockpicker as well as a strategic asset allocator, I’m admittedly a fine one to talk. If you too decide to walk this dubious path, then read some behavioral finance [15]to try to get an edge in deciding what’s a perceived risk versus an actual risk.
As Tim has written on his Psy-Fi blog [16], it’s usually emotion, not the rational judgment of risk, that we should bet against:
Sectors with a buzz about them get rated higher than those with bad vibes. Value investors take note: done properly excess returns can be achieved without real extra risk.
Yet even this isn’t a sure thing. Alan Greenspan famously warned of ‘irrational exuberance’ in the tech stock market in 1996, but it was easy to quadruple your money by riding the bubble in the four years that followed. If you avoid what’s popular too soon, you’ll be risking lower returns.
Ultimately, perceived risk and actual risk are in the eye of the beholder. Only hindsight can be sure which was which.