The academic world teaches that even if a stock price goes up, it is risky because the spread of numbers becomes broad.
My first introduction to ‘risk’ was probably in school. One of the topic taught in statistics was ‘standard deviation’.
The standard deviation is a measure of how spread out numbers are. If the spread is more, so will be the standard deviation.
The linkage of high standard deviation with high risk was taught in my undergrad and then in my masters. Every degree and institute taught me to link standard deviation with risk. I took that as gospel truth and assumed RISK is measured by Standard Deviation.
When your belief is built on wrong knowledge, the distinction between truth and lie becomes a murky affair.
(I have an undergrad from Hindu College, University of Delhi, Master’s from Delhi School of Economics, CFA from CFA Institute, USA and a CFP)
Almost a decade later I reflected on the concept but still never questioned it. It was not before I read Berkshire Hathaway letters that helped me to figure out a rookie mistake.
Here is the rookie mistake:
Stock A price moves from Rs 100 to Rs 1000 in two years. Whereas Stock B price moves from Rs 100 to Rs 200. Stock A will have a higher standard deviation than Stock B. Let’s say Stock A is a consumer company with high ROI and Stock B is an Oil distribution company. Does that ring a bell?
The academic world teaches that even if a stock price goes up, it is risky because the spread of numbers becomes broad.
Warren Buffet (guruji) says risk should be seen in the light of cash flow risk. Let’s reflect on this for a moment.
In any business, there is revenue and there is a cost. The difference is broadly cash flows. As far as the company can increase its cash flows due to growing demand, the company becomes less and less risky.
(Please note that reduced cash flow risk doesn’t mean it becomes an investable company. Investing in a company depends upon its valuation)
Example
Below mentioned are the operating profits for Colgate Palmolive. Colgate-Palmolive (India) is in the business of Oral Care and has a market share of 54% in India.
Below mentioned are the operating profits for ONGC. ONGC is engaged in the business of exploration, development and production of crude oil, natural gas and value-added products.
Now let's look at the share price performance.
You can measure the standard deviation of the price for both the companies, Colgate will be higher than ONGC. Would you invest in ONGC or Colgate? The answer is rather straight forward.
The right measure of risk is the risk of cash flow. This risk can also be measured by the Return on Capital of the company. You need to look at the 10 years or plus history of the company.
(The decline in Colgate’s ROCE is a matter of discussion left for some other day. I don’t want to shift the focus to working capital management and capital expenditure for now.)
So, cash flows and ROCE are ways to assess a company’s risk profile. I would like to add another dimension to risk i.e., unknown unknowns.
There isn’t much to Colgate Palmolive that will change quarter on quarter. However, ONGC being in the oil business will be impacted by a range of issues. These issues could be - a fall in GDP, industrial de-growth, oil constraints etc. Predicting future cash flows of Colgate Palmolive is much easier than ONGC’s. There are too many unknown unknowns in ONGC, making it a very risky business. (BTW ONGC is a government entity, and I am still saying, equity investing in ONGC is riskier than Colgate)
The theory of unknown unknowns can be applied to any financial or non-financial decisions of your life. Often people/media make statements such as “real estate will increase from here on”, “India will be a superpower by 2030” “China can never replace the USA” “So and so stock will increase because of so and so reason” etc. There are so many unknown variables and there is no way you can assign any probability to those variables. My response to all this is “who knows”!
However, what I do know is that if a company has a long history of generating high cash flows with high ROCE, the company may exist for a few more years.
“Time is a friend to a good business and the enemy of the poor business.” – Charlie Munger
A few years back, I went for my first child’s school induction. The CEO of the school asked, when will you allow your child to cross the road by himself/herself?
As per child phycologists, “the answer is - whenever you are ready”. At times, the real risk is not in a situation but in your mind. Someone who understands a particular subject will always have an edge over others. If that person acts on his knowledge, others may perceive the action to be risky but practically he may be aware of the variables more than others.
Similarly, an ex-army man asking his 4-year-old grandkid to jump from 6 feet height, knows that nothing’s going to happen, but others may think it’s a crazy act.
Risk is in the unknowns. If you have seen patterns in your past life whether related to the market or not, a situation may become less risky.
March 23, 2020 (Happy First Lockdown Anniversary!), a countrywide lockdown was announced. At a global scale, the event was novel and there was no past pattern to rely on. Equities had already fallen in a short span. What could have been your thought process?
Well, what happens in a period of crisis? A lot of businesses shut down. When businesses shut down, especially the smaller ones, the value of debt and equity becomes zero. So, the answer would have been - it maybe quite RISKY to be invested in debt than in equity of a large size business. In the academic world, we are taught debt is less risky than equity, but the situation demanded us to think differently.
(In today’s context, both equity and debt may be risky but that doesn’t mean all equities and all debt instruments are risky)
Risk is not a constant, it keeps on changing with time. If you can create mental models and can establish patterns, you can define risk in your own terms.
Disclaimers
Investment in securities market are subject to market risks. Read all the related documents carefully before investing.
The securities quoted are for illustration only and are not recommendatory.
Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.
Details of the advisor
Advisor: Ankur Kapur
SEBI RIA No.: INA100001406
BASL Member ID: BASL1337