Learn From The Masters - When Risk Is Deceptive

By Larissa Fernand
Morningstar India
November 04, 2014
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What does it mean to be happy?

A decade ago, James Montier decided to follow in Adam Smith’s steps and tackle that question. Ironic indeed. Since he himself admitted in the white paper ‘The psychology of happiness’ that they (at Dresdner Kleinwort Wasserstein) have a deserving reputation for being bearish and on occasions, have even managed to depress themselves.

His paper lists 10 things that could probably improve happiness.

Suggestions 1 to 9 need not be viewed in any particular order. A sample of the counsel: Do not equate money with happiness. Suggestion 10 is to remember to follow the above 9.

Montier has a way with words. On the one hand, that makes him a terrific writer. On the other, his controversial observations get him into tight spots. When in Hong Kong during the early years of his career, he wrote a research piece titled The price of the peg, which was about how the Hong Kong dollar exchange rate was fixed, resulting in deflation, causing distress to the stock market and the unemployment situation. His solution? Abandon the peg. The consequence? “The authorities” asked if he might like to reconsider his view or consider relocating. No prizes for guessing which route he chose.

In all his writings, Montier has never shied away from taking bold stands or digs. In fact, he embraces it. Thankfully, his content is often encrusted in humour. (The laugh takes away the sting).

In all his writings, Montier has never shied away from taking bold stands or digs. In fact, he embraces it. Thankfully, his content is often encrusted in humour. (The laugh takes away the sting).

Smart Beta = Dumb Beta + Smart Marketing.

Risk Parity = Wrong Measure of Risk + Leverage + Price Indifference = Bad Idea

(For the uninitiated, smart beta is a strategy that attempts to enhance the return from tracking an asset class by deviating from the traditional market cap-weighted approach. For instance, a fund based on an index is a passive fund that uses market capitalization. But some fund managers seeking higher returns — without having to pick stocks actively — have created investment portfolios based on other measures, such as a stock’s volatility, or a company’s dividends, sales or cash flow

Risk parity has been popularised by Ray Dalio, one of the richest hedge fund managers in the world at the helm of one of the biggest hedge funds. It employs a combination of investments in bonds and stocks to try to adjust for a variety of economic situations such as rising or falling inflation, and rising or falling growth.)

He consistently harps about the folly of forecasting. His advice on the use of forecasts is to not even try because eventually everyone is a soothsayer

He is leery of leverage and calls it a dangerous beast that can never turn a bad investment good. From a value perspective, it has the potential to turn a good investment into a bad one! It can transform a temporary impairment (i.e., price volatility) into a permanent impairment of capital

He concedes that it has its place if you are looking for short candidates, but as a long side value criteria it makes no sense. If your Price Earnings(PE) starts to look expensive, get everyone to look at a less demanding metric- price to sales. If that starts to look tough, abandon the income statement and look at the value based on eyeballs and clicks! Being an authority on behavioral finance, he warns of the consequences of herd mentality and cognitive biases. It is easy to brand Montier as a maverick or financial heretic. But deep down, he is a full-blooded value investor who believes that valuation-indifferent investing will result in tears. That is his Holy Grail of investing. Based on his writings, one can decipher his investing philosophy which is pretty straight forward and can be summed in 5 points.

Valuation is the primary determinant of long-term returns

There is ultimately only one way to generate good long-run returns, and that is to buy cheap assets. Value investing is the only safety-first approach. The golden rule of investing is that no asset (or strategy) is so good that you should invest irrespective of the price paid. No asset is so good as to be immune from the possibility of overvaluation, and few assets are so bad as to be exempt from the possibility of undervaluation.

If when buying a house the mantra is 'location, location, location,' when thinking about any investment (be it an asset or a strategy), the equivalent refrain should be 'valuation, valuation, valuation.' He likens it to the closest thing to the law of gravity that we have in finance.

Always insist on a margin of safety.

The objective of investment is not to buy at fair value, but to purchase with a margin of safety. After all, any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes

An asset can be an investment at one price but not at another. The separation between value and price is key. By putting the margin of safety at the heart of the process, the value approach minimises the risk of overpaying for the hope of growth. When investors violate this principle by investing with no margin of safety, they risk the prospect of the permanent impairment of capital

Be patient and wait for the fat pitch.

Patience is integral to a value approach in many ways, from waiting for the fat pitch, to the value managers' curse of being too early

In an interview with FT Adviser a few years ago, he said that the curse of being a value manager is being too early – too early getting out of market positions and too early getting in

Patience is also required when investors are faced with an unappealing opportunity set. Many investors seem to suffer from an “action bias” – a desire to do something. However, when there is nothing to do, the best plan is usually to do nothing. Stand at the plate and wait for the fat pitch, referencing a baseball metaphor

Patience, he concedes, though integral to any value-based approach, is in rare supply

Be contrarian

Adhering to a value approach will tend to lead you to be a contrarian naturally, as you will be buying when others are selling and assets are cheap, and selling when others are buying and assets are expensive

Humans are prone to herd behaviour because it is always warmer and safer in the middle of the herd. Our brains are wired to make us social animals. We feel the pain of social exclusion in the same parts of the brain where we feel real physical pain. So being a contrarian is a little bit like having your arm broken on a regular basis.

Never invest in something you don’t understand

This seems to be just good old, plain common sense. If something seems too good to be true, it probably is. The financial industry has perfected the art of turning the simple into the complex, and in doing so managed to extract fees for itself! If you can’t see through the investment concept and get to the heart of the process, then you probably shouldn’t be investing in it.

Two years ago, at the CFA Institute 65th Annual Conference in Chicago, Montier condemned theorists, policymakers, and practitioners for creating the financial crisis with “bad models, bad policies, bad incentives, and bad behaviour.”

Risk management assumes that volatility equals risk. He is of the opinion that it creates opportunity. He explains

Was the stock market more risky in 2007 or 2009? Risk managers viewed 2007 as the less risky year because it had low volatility, which was fed into their risk models and concluded (falsely, he notes) that the world was a safe place to take risk. In contrast, these very same risk managers were saying that the world was exceptionally risky in 2009, and that one should be cutting back on risk

According to Montier, this was the complete opposite to what one should have been doing. In 2007, the evidence of a housing/credit bubble was plain to see. This suggested risk. Valuations were high and it was time to scale back exposure. In 2009, bargains abounded, this was the perfect time to take ‘risk’ on, not to run away

Risk managers are the sorts of fellows that lend out umbrellas on fine days, and ask for them back when it starts to rain.

In his paper, I want to break free, he spanks policy portfolios and argues that they, along with various successors such as risk parity, are deeply flawed from an investment perspective specially in terms of mis-measurement of risk and an indifference to valuation

In The Flaws of Finance, he launches an offensive on flawed models, foremost amongst them being value-at-risk, or VaR. This is a tool to measure the size and likelihood of potential losses to a portfolio. So a portfolio with a 1-day 5% VaR of $1 million has a 5% probability of losing $1 million the next day. The calculation is typically based on historical results and the assumption that returns are normally distributed.

According to Montier, it ignores the extremes of distributions. Using VaR is like buying a car with an airbag that is guaranteed to fail just when you need it, or relying upon body armour that you know keeps out 95% of bullets! VaR cuts off the very part of the distribution of returns that we should be worried about: the tails

(A tail is a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution. Though an unlikely and extreme event, on the rare occasion that it does occur, it can be highly significant. Think the global financial crisis. Black Monday was another, when the S&P 500 fell 20% in a single day – October 19, 1987.)

The idea that the risk of an investment, or indeed, a portfolio of investments can be reduced to a single number is utter madness. He prefers Benjamin Graham’s definition of risk which is a “permanent loss of capital”.

That can arise from three sources:

1) Valuation risk – you pay too much for an asset;

2) Fundamental risk – there are underlying problems with the asset that you are buying;

3) Financing risk – leverage

By concentrating on these aspects of risk, investors would be considerably better served in avoiding the permanent impairment of their capital. Risk is not a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure.

He sums it neatly: Value investing is the only investment approach that truly puts risk management at the very heart of the process.

You may disagree with his postulation. But there's no arguing that value investing is synonymous with James Montier.