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Ben Graham Ports and Risk

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By StarryNightShade
December 10, 2004

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In my last post I summarized the results of two portfolios, each of five stocks, created using Ben Graham's conservative and aggressive stock selection rules. These portfolios were created as of 1 May 03 and yielded total returns of 68% and 106% respectively in comparison to a typical index tracking mutual fund which had a return of 30%.

The question I want to answer is this, "did the stock selection method lead to market beating performance or is the increased return due to increased risk?"

To answer this we have to understand the term "risk" and how it might be rewarded and adjust the returns accordingly.

No doubt you have heard that risk = stock price volatility and beta is a measure of volatility. Actually beta is not a measure of total stock price volatility, but only that part which is correlated to the overall market... but I'm getting ahead of myself. It is true that the correlation of an individual stock or portfolio of stocks with the overall market might be correct but only if certain assumptions that were made to arrive at that conclusion are valid. To understand this, let's consider "risk" from the very beginning.

"Risk" is defined in the dictionary (at least the one I have at hand) as "the chance of loss" or "the degree of probability of such loss". When we invest we risk our capital (i.e. "expose it to hazard or danger"). But, this begs the question, "loss of what" or "exposed to what danger". Of course, the loss of the capital invested, or a portion of it, is one such loss, but there are others such as lost opportunities or the loss of expected cash payments such as dividends or interest payments. All of these are types of financial loss associated with an investment.

What's interesting is that the financial loss associated with an investment is relative to some expectation. For example, in the 1930's some people were happy to invest in some "risk free" investments that had a negative return. They did so because other investments seemed riskier. So, "risk of loss" is relative to the expectation of the investor; and because of this subjectivity we have no reason to suppose how "risk" is perceived to constant. It will vary as times change. You might be happy with a bond that currently pays 10% interest on its face value, but if inflation / interest rates were to suddenly soar to 50% you'd have a sense of loss even if you don't cash in the bond.

This subjective nature of risk is going to be a problem in trying to assess how it is valued since valuation does contain a degree of subjectivity. Since we're looking at equity investments, let's consider the components of risk associated with investing in a company.

1) First, the company is subject to overall economic conditions.

2) Second, having taken into account the overall economy there's still the relative fortunes of the industry in which the company operates. For example, the global economies have grown over the past few centuries, but not so the candle making and blacksmith industries.

3) Finally, there are company specific factors whereby the fortunes of a specific company may be different from the overall economy or the industry in which it operates.

As value investors we consider that value of a company not based upon its popularity (you momentum investors, you) but upon its ability to generate cash. Therefore, the company's market value price will consist of the following factors:

1) Expectations for the overall economy.
2) Expectations for the relative performance of the industry within the economy.
3) Expectations for the relative performance of the company within the industry.

There's something else. It's called "uncertainty in expectations". So we have to add this to the overall pricing of the company:

4) Uncertainty.

There is still something else. It's called "bias". It's different from "uncertainty". "Uncertainty" is not irrational; it's a consequence of not being able to precisely predict the future. "Bias" is different. If present it is due to the irrational behavior of investors. It means that they will undervalue the risk associated with popular companies or industries and overvalue the risk associated with unpopular industries or companies. By "popular" I mean a preference for an investment (relative to other investments) that isn't justified by a rational expectation of its performance. I suppose that we could also consider a bias with respect the overall economy, but since the "risk premium" is inherently a subjective concept it's not very useful to do so.

Thus, we arrive at the components that make up a company's market value:

Market value = Value due to economy + value due to relative industry performance + value due to relative company performance + uncertainty + bias.

All of these provide a degree of risk to the investment, but does the market reward all of these risks? Rationally we shouldn't reward a risk if it can easily be avoided. Diversification is a way to avoid the relative risks associated with industries and companies and can even minimize the risk associated with uncertainty. That's easy to understand. If the overall economy is unchanged, then if one industry performs less than expected other industries must have performed better. So, the diversified investor will have experienced a "loss" in one part of the investment portfolio and "gains" in other parts. The same is true for a company's relative performance. Diversification also helps with "uncertainty". It's sort of a case of overestimating as often as you underestimate so that with enough investments these balance out.

However, diversification will not eliminate overall economic risk, since we can't escape the overall economy. Neither can we eliminate "bias" with diversification since "bias" is a market wide "prejudice" for or against an investment.

Now we come to philosophy. The assumption that the market is "efficient" is claiming that there is no "bias" and that risk represented by overall economy is the only "risk" factor that will be rewarded. Therefore it's only the sensitivity of a company to the overall economic that will affect its market value. For example, a highly leveraged company will do much better in terms of "return on equity" with low interest rates and much poorer with high interest rates than a company with low debt.

Notice that it's the sensitivity of a company's performance to the overall economy that is the real component of risk here not price volatility or beta. So how does price volatility come into this? As we said earlier, "WE ASSUMED THE MARKET WAS EFFICIENT". That means that the market value should fairly and accurately reflect the company's sensitivity to the economy. Therefore, measuring the correlated price changes of the company against the overall market valuation should lead to a reasonable estimate of the degree of overall economic risk associated with a company. Note that beta is NOT a measure of overall price volatility only that correlated to the overall market. An equity could have a beta of zero. That doesn't mean that it won't experienced price changes; it's just that these changes are completely unrelated to the market.

Great, hallelujah! We have to solution for all time to investing. Invest in higher beta stocks and we'll automatically get a higher return. Right? Not so fast. There's no guarantee that the economy will perform as you expect. "But surely", you say, "all I have to do is wait a long time." Consider this: even over a 25 year investment period you can not guarantee that the overall stock market will beat risk-free investments. Over the past century, for 25-year investment periods starting in mid-January each year, there are 12 occasions for which risk free investments had superior returns to the stock market. If you had a high "beta" stock portfolio you could reasonably expect that there would have been even more occasions in which you would have poorer returns than a risk-free investment. Food for thought. Remember this: the greater the volatility in the expected return over a given investment period, the more likely you are to have a return less than a risk-free investment.

There is one problem with using market-correlated price volatility or beta as a substitute for a company's market-related risk, which is that economy, industries and companies change in time. The sensitivity of the company to the overall economy will NOT remain constant. For example, if a company pays off its debt it will be less sensitive to changes in interest rates. Therefore, there is no guarantee that the value of beta based upon historical information will be useful to predict a company's performance in the future. There are studies that show that betas based upon historical data is explain somewhere between nothing and about a third of a diversified portfolio's return. Wow! Impressive...hardly. Either companies are extremely dynamic in their relationship to the market, or the market's not as efficient as we thought.

Still it is clear that "volatility" is related to risk. Even if it's hard to predict maybe we can still use it retrospectively � but keep this in mind; the historical volatility over a period of time might not necessarily have been what investors expected at the beginning of that period of time. And there is still one more thing to consider. Don't forget! There's that pesky thing called "bias". The evidence is clear even to die-hard efficient marketers. The market does exhibit "bias". [Nortel at it's high point anyone? Even Nortel executives had a hard time rationally explaining that degree of valuation.] I don't suppose anyone on this board doubts the existence of market "bias" since value investing depends upon it.

There are a few problems with exploiting "bias" in the market. The first is finding it; and the second is that we have to hope that market eventually changes its mind. The first is difficult due to uncertainty, which is why some investors demand large "margins of safety". The theory here is that the larger the margin of safety the less likely the identified "bias" will be due to uncertainty � and that is a reasonable assumption. The second problem is more difficult to deal with since if the market never changes its "bias" the market will behave as if it were efficient (i.e. reward risk is due only to market correlated price volatility). So to benefit from identified biases it must be supposed that in time the market will adjust to a rational valuation of companies that are valued with a bias. Note that it must do so before a company's financial state changes that could make it appear that the market's bias was justified (i.e. the market appeared to be right but for the wrong reason.)

Thus there are two things to consider when adjusting for risk in a portfolio to determine if its risk-adjusted return truly did beat the market, which are the portfolio's sensitivity to the overall market and the effect of market bias.

Next post I'll show two ways of assessing the Ben Graham portfolios that take risk into account.



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