Investors often mix risks and uncertainties, but in fact they are different concepts. Understanding differences can not only help you avoid your next investment mistake, but also open your eyes.
For beginners, let’s clarify the risks. The real investment risk is the permanent loss of capital. In other words, asset devaluation will never recover.
Cautious investors who understand basic financial statement analysis can limit the risk. However, there is no barrier to eliminate the uncertainty. Even the best investors, they will still “periodically cause paper damage” in their portfolios (ie, temporary price fluctuations).
However, there is a glimmer of hope associated with uncertainty. Uncertainty runs the risk in the minds of many investors, creating a price misalignment.
As an investor, I try to get rid of the risk and move towards uncertainty. Here are two case studies explaining why.
Case Study # 1: Pride of Pilgrims
In the early days of my career, my pride was overwhelmed by a stock called Pride of Pilgrims.
In 2008, I was a security analyst at a large company. At that time, I thought I was a budding “value investor”, for me it meant buying cheap things when others were not willing, holding their nose and waiting for a turn for the better.
One day, I ran a screen that consumed the major stocks, the largest decline in price over the previous year. This type of screen always produces a list of problem stocks, but it can also find hidden values. Pilgrim’s Pride (ticker symbol: PPC) caught my attention on the list. PPC is one of the major poultry producers in the United States. The stock is cheap and the transaction price is close to the book value.
A closer look at the report quickly showed that the major drag on PPC was oversupply in the market, which depressed poultry prices.
However, analysts have come up with a convincing example that the industry’s production cuts may occur, resulting in a rise in profitability. This usually leads to a sharp stock rally.
I wrote down the stock idea and submitted it to the Investment Policy Committee. The chief decision makers of the company listened to several questions, made some suggestions to me, and thanked me for their analysis.
They never bought shares, the result is a very wise decision. A few weeks later, a perfect storm hit PPC.
The company has already hedged the significant cost of inputs – feed grains – before the price of corn and soybeans plunged. Meanwhile, as the economy deteriorated, the chicken prices continued to slump, causing the profit margin to decline.
Companies can absorb loss trauma if they have a strong balance sheet. PPC did not, however. In 2006, the company took heavy debt to complete an expensive buyout.
When dislocations began to spread in the credit markets in 2008, many of the companies that previously skated on thin ice suddenly fell out of the lake. PPC is one of them, eventually applying Chapter 11 bankruptcy.
When the stock started to soar, one of the senior portfolio managers called my desk. “Hey Michael, what are the benefits of PPC?”
Gulp. I hope he did not notice.
Awkwardly, I try my best to sum up the collapse.
He listened, nodded, and said: “Ok, thanks.”
Relieved, I walked away, stumbled. He may thank me? I almost put the mine into the portfolio!
In retrospect, I am very grateful to my boss for treating me that day. why? Because he let me fail and learn. I now realize how important it is to survive in this industry. Everyone makes mistakes. The key is resilience, reflection, and constant improvement.
If he beats me, I may try to defend my analysis and accuse the PPC manager of being ineffective. This is a common response to a bad investment decision – blame others. Behavioral finance even has a name – this is called regret avoidance.
I was fortunate because I had a chance to consider my own mistake because it gave me full responsibility for what I missed in my analysis. PPC is my first lesson, that is, excessive portfolio quality, especially in late-cycle environments. The two main ways I define quality include:
High return on capital, stable
PPC neither these characteristics, but also risk. The company’s weak balance sheet and the profitability of its various commodity markets – all of which are volatile and hard to predict.
Last week, Facebook chief executive Mark Zuckerberg announced that the company would change its news feed to prioritize the content of family and friends. This has caused these changes will inhibit the uncertainty of advertising sales. Poor stock prices, the next trading day fell more than 4%.
Facebook (stock code: FB) What is the meaning of a good stock. More than 2 billion active users each month bring a strong network effect to the company, which is very hard for competitors to copy. The company has zero debt, generating a 24% return on equity and emerging free cash flow.
Although the value of the company has soared in recent years, it is not immune to cyclical failures. A long time before advertising revenue soared, many doubted Zuckerberg’s ability. They encouraged him to sell the company, but he persevered.
Recently, he was criticized for paying a multiple of Instagram and WhatsApp. Now, these seem very smart move.
There is always uncertainty about innovation, but Zuckerberg has proven to be smart and capable of overcoming challenges.
If a company’s core economic DNA is as powerful as Facebook, the risk of permanent loss is usually small. There are more reasons to doubt if they have the habit of overcoming temporary setbacks.
You almost never have a chance to buy a high-quality, composite machine like Facebook at a bargain price. Short-term callbacks usually produce the best buying opportunities. This is why an event that meets the “uncertainty challenge” is an opportunity, not a risk.
Such games have the advantage of being asymmetrical. Ideally you buy one to fall and see a quick bounce. If you are early, you pay more in the short term. However, your downside risk is reduced because if you have identified a qualifying quality asset then the company may increase the price you pay and drag you out. There is a safe edge.
On the other hand, low quality stocks may not have the inherent value of growth at all – it could undermine value if the firm does not receive the cost of capital. Trying to seize a knife that descends like this may result in deeper cuts because you risk too much, plus value creation is bad for you. Cheap can get a lot cheaper.
Risk rewards are important to all investors. After 2008, I paid more attention to this issue, especially in the late bull market.
If your goal is to survive and grow in your long-term investment pursuit, stay vigilant and combine risk with opportunity. Distinguishing between the two will help you avoid the value trap and stay ahead of most market participants.