November 4, 2010

Risk is losing money, nothing else. There are other measures and analyses of risk but Value at Risk, CAPM-derived betas and equity risk premiums, tracking errors and other such measures are of no help when investing using a low-turnover, concentrated, long-term value style. Only thinking of risk to one’s capital money makes sense.

Equities are a risky asset class, with high volatility, grinding bear markets and occasional gut-wrenching drops (think 1929, 1987, the “flash crash” of May 2010). Cognisant of this, one must expect to lose money on individual investments sporadically and in the short term. In the longer term, however, it should be possible to minimise risk to one’s capital. An investor has to accept this risk, to avoid a greater risk – not owning real, inflation-resistant assets and losing purchasing power in the longer term (remember that $1 in 1900 has lost 90%+ of its buying power). Adopting an overly short-term and risk-averse mentality will mean a lack of exposure to real assets, exposure to which is necessary to deliver decent returns in the long run.

There are two key aspects for controlling risk (as we define it, i.e. losing money in the long term), which are margin for error and diversification. Margin for error applies mainly to individual investments, and diversification applies to the portfolio as a whole.

Margin for error comes from buying a stock where the long-term intrinsic value of the operations is significantly higher than the price. Importantly, this estimation of value must be conservative with limited assumptions about the unpredictable future. If opportunities such as this can be identified, an attractive risk-to-return investment is available. At Kennox, we have developed a process to identify these types of stocks and we believe that all of our stocks have a margin for error.

However, stock market investing is intrinsically chaotic. This is due to the incomprehensible amounts of information and the subjectivity (accrual accounting is based on estimates and assumptions, often biased and prejudiced), which is then compounded by the inherent unpredictability of the future. In order to protect against this, a robust portfolio must have genuine diversification, by which we mean that one issue won’t negatively affect a significant portion of the portfolio. You don’t want your soldiers lined up so that one bullet, however unpredictable a direction it comes from, will kill them all.

Regarding formal limits, such as by sector or by region, we are agnostic towards the MSCI or other financial indices. Even on absolute levels, we do not enforce strict limits, such as no more than xx% in Asia, or no more than xx% in banks. As per our stocks, we analyse what the long-term risk-to-return profile is for any region, country, sector, or industry, and use this to avoid overconcentration of risk. We review this regularly but, as with our stocks, we are analysing the long term. This mean that large radical shifts in our opinions are rare. Such a top-down view and considered analysis of the world is useful for identifying a variety of potential pitfalls which should in turn lead to lower overall portfolio risk and better returns.

We at Kennox tend to avoid the current view of risk as variation or volatility of returns. Instead we use the traditional definition of risk, that of losing money. It is nothing but the logical outcome of the style and objectives of the Fund.

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