Risk first, Return second

“Invert, always invert” is a famous, often cited quote of Charlie Munger, the 86 year-old billionaire investor better known as the other half of Warren Buffet’s Bekshire Hathaway operation. Simple as it sounds, I hadn’t until very recently come across practical examples of its application.

Sure, many investors these days claim to have a unique approach to their craft; focusing on areas where others dare not tread and supposedly “going the “extra-mile” in their search for an informational advantage. But merely being thorough in due diligence, inquisitive in one’s approach to the stock selection process, does not constitute a novelty anymore. On last count there were more than 7.000 US based hedge funds out there, and you can rest assured that not one of them has been standing around waiting for opportunity to knock on their door.

And yet, in spite of the large research teams sported by these outfits, the millions spent on all manner of screening tools, specialist publications, analyst conferences and proprietary research, little variation is seen in the returns of most participating institutions. There are however some exceptions.

Cue in a gentleman by the name of Mark Sellers, of hedge fund Sellers Capital. Browsing through a transcript of a speech delivered some two years ago, I unearthed the following gems:

“We spend nearly all our time calculating worst-case scenario valuation for a stock before we buy it”.

As a matter of fact, Sellers goes on to specify the quantitative process followed to determine the risk/return ratio threshold required before committing actual capital:

“We look for stocks that have at least 3 times as much upside potential as they have downside risk. So, for example, if the worst-case scenario fair value for a stock is, in our estimation $24, and the current market price is $30, that’s 20% downside risk. If we are wrong, we lose 20%. So we need to feel comfortable that if we’re going to risk losing 20% on a stock, we expect to make in a reasonably likely scenario, 60% or more. As such we would only buy this stock if the fair value in a likely scenario was $48 or higher”.

Obvious as this technique may sound, it is far from commonplace. Can anyone remember the last time they read and analyst valuation report that spent more, or even an equal amount of effort, to value the downside as it did the upside?. 99% of the material I read focused on potential growth patterns and future cash flows as a justification for a soon-to-be-met stock price.
More importantly however are the criteria used by Mr. Sellers as he approaches valuation, be it worst case of best case.

Unlike the chronically over-optimistic equity analysts (especially those with patent conflicts of interest at their investment banks), our man of the day, relies on tangible, fungible assets to determine true current value. Put simply, the $24 worst case valuation mentioned above would represent the liquidation value of the company in question, should it be forced to cease its commercial activity. This to me represents a true margin of safety!.

Returning to the opening remarks of Mr. Munger, it seems that “inverting” of focusing on what could go wrong before shooting for the sky is one clear way to market beating returns.
Just imagine what kind of returns the average mutual fund company, stuffed with supposedly “blue chip” financial stocks like AIG, Lehman and Citigroup, would have obtained in the period 2007-2009 had they focused on the downside as opposed to the beautifully crafted forward 5-year earnings models touted by the Street. Some funds might even have made money!.

A little time spent understanding the true value of those loan books and ignoring the momentum trading mania of late ’07 would have steered them clear of impending trouble. Difficult as it is these days to unearth truly undervalued businesses, they do exist (see BP in July 2010), and, at a time when fixed income markets deliver an almost return-free rate of risk, I would follow the likes of Sellers and Munger and turn the investment process on its head.

“Focus on the downside and the upside will take care of itself”
Mark Sellers, 2008