How to assess investment risk from a permanent loss of capital perspective.

When you invest, you have to think not only of the upside. You also have to worry about the downside — what many consider as investment risks.

The challenge has always been how to assess this risk in a practical manner. In investing, there are 2 schools of thoughts on risk:

  • Those that view volatility as risk.
  • Those that view a permanent loss of capital as risk.

The volatility school has strong academic credentials. This branch of finance theory has developed to a stage where you can numerically bring risk into the valuation process.

Many fundamental investors look down on those that consider volatility as risk. To them, if you have a long-term investment horizon and do not crystalize any losses due to volatility, you will not incur a permanent loss of capital. As such they do not consider volatility as a risk.

Unfortunately, the permanent loss of capital school does not have an alternative theory where you can numerically bring risk into the investment process. All their discussions on risks as permanent loss of capital are qualitative.

I would argue that despite the qualitative nature, you can still methodically bring the permanent loss of capital concepts into the investment process. This can be achieved through a risk management approach comprising:

  • Identifying the possible causes that can lead to a permanent loss of capital.
  • Assessing the threats.
  • Mitigating permanent loss of capital using risk management strategies. It involves avoiding, accepting, reducing, or transferring them.

This risk management framework provides you with a way to bring risk into your investment process although on a qualitative basis. It can also be used to compare the permanent loss of capital for different stocks.

Contents

  • Risk Management framework
  • Step 1 — Identifying the possible causes for permanent loss of capital
  • Step 2 — Assessing the threats
  • Step 3 — Identifying the risk mitigation measures
  • Comparing the risks of investing in different stocks — a case study
  • Pulling it all together

Risk management framework

If you consider a permanent loss of capital as risk, there is no reason why we cannot adapt the enterprise risk management framework to manage investment risk.

The risk management process involves the following:

  • Identifying the causes that can lead to the risks.
  • Assessing the risks in the context of the impact and the likelihood of the occurrence.
  • Formulating the mitigation measure to manage the risks.

The strategies to manage them cover:

  • Avoidance — what can be done to prevent it from happening.
  • Reduction — how to minimize the impact of any risks.
  • Transfer — is there a way to transfer the risk and/or the consequences to another party?
  • Acceptance — in some instances where the cost of mitigation outweighs the benefit of the mitigation strategies, it may be better to live with the risk.

I proposed a 3-step framework to identify, assess and mitigate risks from a permanent loss of capital perspective.

Step 1 — Identifying the possible causes for permanent loss of capital

To suffer a permanent loss of capital, the investment has to be sold at a price that is lower than the buying price. I will ignore the situation where the investment has been sold due to short-term volatility.

The task is then to identify the reasons why the price is “permanently” below the purchased price. These could be due to the following direct reasons:

  • Deterioration in the intrinsic value due to changes in the fundamentals — both macro and micro.
  • Issues with portfolio construction.
  • Wrong assessment of intrinsic value in the first place.
  • Stock market changes due to regulatory changes

These are the main or direct causes and there are other root causes for each of them.

To help identify the root causes, I have used the Ishikawa diagram. This is a diagram that shows the causes of an event. It is often used in manufacturing to outline the different steps in a process and demonstrate where quality control issues might arise.

It is sometimes referred to as a fishbone diagram. It resembles a fish skeleton, with the “ribs” representing the causes of an event and the final outcome appearing at the head of the skeleton.

The fishbone diagram below illustrates how the root causes feed into the main causes. If you want further explanation of each of the root causes, refer to “Baby steps in assessing Permanent Loss of Capital”.

The above Ishikawa diagram shows the first level cause-and-effect. You can have a second or even third-level cause-and-effect diagram for the more complex cases.

For example, in the case of the External factors, you could further break it down into

  • Different economic factors eg interest rate, GDP growth, inflation.
  • Different social factors eg demographic trends, migration patterns

How do you differentiate between the main risks and root causes? Since they are supposed to be cause-and-effect, I classify an item as a cause if the problem (the effect) is resolved once I addressed the cause. If it is not resolved, either it is not a cause or there is no cause-and-effect.

Of course, we may differ in what we consider the main risks and/or the root causes. It really does not matter as long as it is comprehensive enough.

Step 2 — Assessing the threats

The goal of threat assessment is to evaluate the likelihood of occurrence of each of the threats and the impact.

I classify each causes in the Ishikawa diagram into one of the following 4 colored cells based on the assessment of its impact and the likelihood of it occurring as per the table below.

The threat assessment will enable you to prioritize the threats. It is obvious that you first address those with high impact and high chances of the event happening. The lowest priorities are for those with low impact and low probability of the event happening.

Step 3 — Identifying the risk mitigation measures

Given the various items that can lead to a permanent loss of capital, the risk mitigation approach is to identify various measures to handle each one of them based on the following 4 strategies.

  • Avoiding the threats. For example, you could avoid penny stocks and invest only in blue chips.
  • Reducing the likelihood or impact of the threats. One possible way is to have a checklist or standard methodology to reduce any behavioural biases.
  • Accepting the threat. A common approach would be to have a portfolio of stocks so that if one does badly, the others may do well enough to more than offset the bad performance.
  • Transferring the threat. This can be achieved by having an asset allocation plan where some of your net worth invested in properties and bonds. These have a different risk profile than those of stocks.

Each investor will probably fine-tune the measures to adopt as these will depend on the investment style, risk tolerance and personality (behavioural biases) of the individual.

To illustrate this step, I summarize in the following chart the measures that I have adopted.

You will notice that some measures cut across several risk mitigation categories. Furthermore, if you view the threat as a function of both the likelihood of the event and the impact of the event, then depending on the nature of the threat:

  • Some of the measures focus on the likelihood.
  • Some focus on the impact.
  • Some cover both likelihood and impact

The focus of this article is on the framework so I would not go into details of the rationale for each of the measures. For those interested in the details you can refer to the article I mentioned earlier.

Comparing the risks of investing in different stocks — a case study

I am a bottom-up long-term value investor. I value companies as part of my investment process using the discounted cash flow (DCF) method.

When I value companies using the DCF method, I discount the free cash flow using a discount rate that reflects the time value of money and the risk of the cash flow. A risker investment is one with a higher discount rate and vice versa.

I used the Capital Asset Pricing Model (CAPM) to determine the discount rate. Under the CAPM, the risk is reflected by the Beta. The problem with this approach is that both the CAPM and Beta are based on volatility.

I know it is ironic that for someone who does not view volatility as risk, I use a volatility measure when bringing risk into my valuation process.

Unfortunately, I have not been able to find any numerical technique based on the permanent loss of capital concept to do this.

Having said this, I believe that the framework I outlined can provide one way to compare risks between different investments. To illustrate this, I have a case study where I compared the investment risks for 2 Malaysian companies as per the chart below.

To be able to assess the threats there is a need to first analyze the companies. Such analyses have been carried out for 2 companies whose details can be viewed from the following articles.

For each company, I categorized each of the causes of permanent loss of capital (as per the Ishikawa diagram) into the relevant threat category (as per the Threat matrix). The results are then summarized in the chart above.

Based on a visual comparison, you would conclude that an investment in Asia File would have less risk compared to a similar investment in Eksons.

The above is mainly a first-level cause-and-effect assessment (although I did go down to the second level in the case of the External factors). You can go down into a second or even third-level cause-and-effect assessment if need to.

The rationale for my assessment is summarized in the following Notes

a) Any regulatory issues affect both companies equally.

b) Because of the shareholders’ profile and cash available in the company, I consider a greater likelihood of Eksons being privatized. Of course, whether you suffer a permanent loss of capital would depend on your purchased price.

c) Since both stocks are in the same portfolio, they share the same risk profile, and hence I have not attempted a finer breakdown.

d) I use the same analytical process for both so they share the same assessment. My margin of safety minimizes the impact of any error here.

e) I relied on my rating system (Q Rating) to assess Eksons to be riskier. My margin of safety minimizes the impact of any error. You could employ any governance assessment approach for this.

f) Eksons has a simpler business model and hence fewer analytical and valuation issues.

g) Both companies are financially strong.

h) Asia File is more likely to face digital disruption.

i) Eksons is facing log supply issues resulting from the government logging policies.

j) Asia File management has a stronger track record.

Pros and Cons of the methodology

The goal of the assessment is to have a standard way of comparing the risk between several companies. A visual assessment serves this purpose.

Unfortunately, it is not very meaningful if you want to assess the risk of just one company. I see the following as the Pros and Cons of this approach

Pros

  • Simple visual assessment
  • A consistent basis to compare
  • Relates to the reasons for permanent loss of capital ie risk

Cons

  • Requires detailed analysis of each company.
  • May not be practical if comparing many companies together
  • Different parties may come to a different assessment
  • Dependent on identifying the correct cause-and-effect

Pulling it all together

With the permanent loss of capital as risk, you can adopt the risk management process to assess risk and bring it into your investment process.

The risk management process involves identifying the threats, assessing, and then mitigating them. The mitigation measures involved avoiding, reducing, accepting, and transferring the risk

I proposed a 3-steps framework to methodically bring the permanent loss of capital into the investment process.

  • Identify the causes of the risk using the fishbone diagram.
  • Assess the likelihood and impact of each of the threats.
  • Formulate various measures to mitigate a permanent loss of capital

I will be the first to recognize that this is a qualitative approach and is not as elegant as the numerical approach that considered volatility as risk. However, I believe it is a practical approach and would be useful to many newbies trying to bring risk mitigation into their investment process.

He was formerly on the Board of i-Berhad from 1999 till 2020. Currently blogs on i4value.asia sharing his value investment insights in the form of case studies

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