Rethinking Risk: Volatility vs Bankruptcy 

In this issue of YAIN, we pause for a moment from our training to focus on the likely reason you subscribed to this newsletter: how do we pick the securities we invest in? Before going into details, we need to make a controversial, but very much needed statement. We believe that the definition of risk is widely misunderstood, or at least our perspective of it is different from the conventional one that you may have heard from your private banker or by looking at funds’ factsheets. 

Traditional finance considers price fluctuations risky, so also the measurement of risk revolves around that. You might have heard of  metrics like standard deviation, variance, or Value-at-Risk (which is complete nonsense), all of which stem from this assumption. There are valid reasons to view frequent price movements as risky: if you need your money at a specific time and prices drop, you could be worse off. Thus, less volatile securities might seem preferable. However, we believe that one should invest money for the long term and be indifferent to short-term fluctuations. From this perspective, price movements don't matter as long as we remain invested in sound businesses and we stay solvent.

Hence, we would rather own volatile securities that grow over time than stable ones with flat returns. In plain terms, we are comfortable seeing our portfolio lose 50% in a given year if (i) we survive it and (ii) it results in higher long term gain. 

Yet, volatility does matter when it leads to bankruptcy. In the hypothetical graph above, the blue line represents a low-volatility, low-growth portfolio, while the red line shows higher volatility but higher growth. By our reasoning, the red line seems preferable. However, notice that around period 6, the portfolio represented by the red line turns negative: you’re bankrupt! Once your capital is gone, compounding wealth is no longer possible. These concepts have been deeply studied by John Larry Kelly Jr. (a physicist) and  by Edward O. Thorp (a mathematician); the Hollywood movie 21 is based on the latter, however they never became quite popular in mainstream academia. From a more pragmatical point of view, Warren Buffett encompassed these concepts when saying

To summarise: for us, true risk lies in the permanent loss of capital, ie: bankruptcy! Therefore, our focus shifts from minimizing price volatility to maximizing long-term returns while mitigating the risk of permanent capital loss. We are comfortable with volatility if it translates into above average long-term capital growth.

A Quest for Compounders

As we don’t care about price-fluctuations, it should not come as a surprise that we prefer investing in equity rather than in bonds (you may recall their definitions here). In fact, the average annual return of the S&P 500 over the last 30 years (as of 2024) was approximately 10.73% (including dividends) and when adjusted for inflation it was about 8.43%, whilst the average annual return for Bloomberg US Aggregate Bond Index over the past 30 years has been around 6% gross of inflation or 4.3% net of inflation. The graph below shows your compounded wealth if you invested in stocks vs bonds.

The main reason we prefer companies over other asset classes is their ability to compound over time. Let’s pause one second as we have already mentioned it a few times, but never defined it: what is compounding? Compounding is the ability of something to grow exponentially over time by the repeated addition of the proceeds generated to the principal invested. Investments compound when we earn money not only on the initial amount invested, but also on the money generated by that investment. Companies enjoy compounding as they can invest their profits in other projects, whilst bonds and commodities cannot. However, money is not the only thing that compounds. When you reflect on this powerful concept, you will realize it applies to education, sports, art, and most pursuits that require consistent effort. Over time, the improvement becomes more than just linear...it accelerates! And this is the key: compounding unlocks for you the power of exponential growth.

When you invest in companies, especially listed ones, one may look at different variables, both quantitative and qualitative. Our investment approach is to seek to be long term investors in good companies that we understand. We define good companies as the ones that enjoy:

1. high profitability 

2. growth; and 

3. ability to maintain competitive advantages.

This approach aligns directly with the principle of compounding: (i) Consistent cash generation provides the fuel for compounding, (ii) growth allows for effective reinvestment, and (iii) enduring competitive advantages ensure that this cycle can be repeated over the long term. Because compounding is an exponential function, its full potential is realized over extended periods. As compounded returns are significantly affected by starting valuations, we are looking to invest in companies whose valuations are considered attractive. As long as the characteristics above (business and reinvestment opportunities) remain in place, we are likely to hold companies in our portfolio indefinitely. Which basically means that we like to buy quality stuff at a fair price. How does this reconcile with the Kelly & Thorpe approach discussed above? We are looking for companies at fair prices that will not go bankrupt (otherwise our capital goes to zero) and keep on growing profitably for the foreseeable future regardless of the volatility of their stock price: we care about their business operations as that ultimately drives the value of the company and we have already seen that ultimately the stock prices are correlated to earnings.

Stocks Are Not Lottery Tickets

We  firmly believe that stocks are not speculative instruments for getting rich overnight, but rather fractions of actual companies run by people creating and selling tangible products. With this perspective, we view ourselves as co-owners of these companies. Naturally, our goal is to generate returns, but we expect this to happen because we believe in the company’s ability to deliver superior products, leverage strong distribution channels, and sustain high profit margins with growth potential. For instance, when grocery shopping, we prefer buying products from companies we own, not only because we trust their quality and believe they are superior but also to avoid indirectly supporting their competitors. Simply put, we think and act like owners.

There are a lot of synthetic metrics we look at to reduce the companies we like to analyse, such as revenues / EPS growth, ROIC/ROCE, FCF / shareholder yield, all of them will be explained in greater detail in the coming newsletters. However, it is important to highlight that there is no combination of filters on any database that will give you the perfect set of companies to invest in. As mentioned, we consider ourselves co-owners and therefore we will make a lot of qualitative assessments, such as on the management team, judgment on their go-to-market strategy, total addressable market, geographical segments in the next 100 years, etc… as we would do if we’re buying the bar round the corner: you don’t want to work with horrible people or invest money in a terrible cappuccino. This approach may result in considering investable companies with average metrics, based on capital preservation, as well as listening to hours of earnings calls and studying very horizontal topics, such as history, geography, politics, anthropology, psychology, biology, medicine, engineering, etc…

Understanding the Business

We spend a decent amount of time when assessing the investability of a company trying to understand how that company makes money. When first reading the financial statements and/or the company investor’s presentation, the first reaction may be “of course I get it”. However, some companies have complicated technologies, patents, regulatory approvals, that are fairly difficult to assess if you’re not an expert in that industry, let alone forecast their future trends. Hence, our first best would be companies that do very simple stuff that we can understand inside-out: manufacturing, simple technologies, services, and so on. Very prudently, we make exceptions to this rule, when looking at quasi-monopolies. For instance, Novo Nordisk, ASML, and Google may involve a fair amount of patents, technicalities, and high-level engineering to fully understand their prospect, but we reckon they are currently in a position to safely preserve our capital.

Profitability & Growth

As trivial as it may sound, we like companies making money. There are a lot of people seeking spectacular and usually short-term returns attracted to unprofitable companies with the likelihood to become the next Tesla, who too often forget to check whether that company will ever become profitable. As a matter of fact, to date we do not like the actual Tesla as an investment target, let alone the wanna be ones. In fact, we like companies that have shown a consistent track record of growing profits.

The rationale is simple: if a company is not able to generate enough revenues to cover its costs, it will need to find money elsewhere: either as debt or as new shareholders. In both cases, that company will rely on third parties to survive and that will eventually affect its business choices. In case of debt, interest payments may affect day-to-day operations and cash-flows, whilst adding new shareholders may on the one hand dilute our investment and on the other hand be a constant drug the management needs to stay in business. Of course, this means that we may miss a lot of opportunities that may 10x our investments, such as Tesla itself or Uber, but we also missed a lot of bad ones, losing a lot (or all) of money. 

A good example of this is Nikola Corporation, often named the “Tesla of Trucking”, which delivered a spectacular return of -99.54%, despite at some point its price went from 300$ to over 2,000$ and there were a lot of gurus on social media flexing about it.

Valuation

Unfortunately we are not the only ones out there searching for easy-to-understand, growing, and highly profitable companies. Given that the short-term price of a company is driven by demand and supply, the best companies (but also a lot of bad ones with hype) can become quite expensive. For example, when buying apples it is easy to determine whether they are pricey by simply comparing the average price of apples across grocery stores. Many investors try to do the same for companies, but we believe they might end up comparing apples with pears (or with Pokemon Cards). Ideally, we like to buy companies when they trade below their intrinsic value, which unfortunately is not always straightforward to calculate as it will depend on a few assumptions. In fact, we usually do not buy stocks only hoping to sell them after a while at a higher price: we buy companies that may compound value over time by generating more and more earnings and returning this value to shareholders.

Furthermore, many investors tend to reduce the valuation of companies to multiples such as Price-to-Earnings (or P/E) as if they contain all the necessary information to assess whether a company is undervalued. We will discuss valuation in a separate letter, but for now let’s just say that we seek to pay prices that will generate higher expected returns than those of long-term treasury bonds. Hence, we will not overpay as otherwise the investment  would likely result in lower returns over time, but we will not only look at those companies that are trading with low multiples such as P/E: if we find those we will be happy to assess them, but if they turn out to be companies that have very limited profitability, zero growth, or no competitive advantage we will pass.

Do Nothing

And then the most difficult part, we sit and do nothing. We spend hours evaluating a company, including reviewing its management and their track record as well as transparency and integrity. Hence, we will not be bothered by market movements or news and if the stock price of that company fell 20%, until our investment thesis is intact we will buy more, not less of that company to increase our exposure. We periodically re-evaluate financial statements of our investments, looking at both their quarterly and annual results, but without letting short-termism affect our strategy unless we find something affecting the long-term outlook of the company. Therefore we sell our holdings only if: (i) main source of revenues change in something we do not understand; (ii) major impact on future growth / profitability; (iii) prices become unreasonably high (not just high); (iv) we find other opportunities with better risk/return ratio (i.e. same growth/profitability but better valuation or similar valuation but growing faster / more profitable); (v) change in management resulting in people with opaque policies or shadows of lack of integrity. 

Conclusions

It is important to highlight that the characteristics described above are independent of a company’s industry, size, geographic location, target markets, and therefore we remain agnostic of all of these factors. However, basic math will tell you that if you are looking to 100x an investment over years smaller companies and growing markets may be the place to look into. In fact, it is much easier that a company worth $1 billion will be worth $100 billion, than a company worth $2 trillion will be worth $200 trillion. This is similar to Monopoly, where prices  (e.g. Park Lane) are inevitably linked to the amount of money in circulation. To illustrate the idea, $200 trillion would exceed the GDP of most countries combined, which is economically unfeasible. Nonetheless, this does not mean that we will only be investing in hidden micro-cap, as we will be discussing several big companies as well. However, both for the above reasons and to add value to our readers (there are already plenty of analyses on Microsoft on the internet, much less on smaller or non-US companies that are growing fast and profitably), it is more likely that we will analyse smaller or non US companies.