Investment is a process by which one incurs short-term inconvenience in the expectation that it will generate long-term benefits. To invest is to forego consumption today, accumulate savings and exchange one’s savings for titles to property (such as businesses, real estate, bonds or other debt instruments). One exchanges cash for titles to property because one expects that the property will generate a stream of earnings sufficient to finance a desired level of consumption tomorrow, the day after and into the indefinite future. In Warren Buffett’s words, “investing is laying out money now to get more money back in the future – more money in real terms, after taking inflation into account.” If one’s perspective extends over several decades then the ownership of businesses has generally (but with some notable exceptions) produced a larger stream of income than ownership of real estate and bonds; and the stream of income derived from the ownership of real estate and corporate bonds has generally been larger than the interest payments paid by governments on their bonds or banks on their cash deposits.

At the same time, however, to invest is to make assumptions about the future. But the future is uncertain, one’s assumptions may not transpire and hence risk inheres in any investment. Indeed, in at least one respect the greater the anticipated returns from an investment the greater the risk which attaches to that investment. A bank and a Commonwealth Government bond, for example, are ‘risk-free’ assets in three senses: first, the likelihood that a default and permanent loss of capital might occur is, for all practical purposes, nil; second, their interest payments are fixed; third, they are virtually assured and (given a particular yield) almost perfectly predictable. For these reasons the stream of income generated per dollar invested in these assets tends to be relatively small.

Real estate tends to be a riskier asset because the likelihood of bankruptcy, liquidation, etc., whilst still generally very small, is not negligible. Further, rental income is more variable, less predictable and less assured over time than are interest payments from banks and governments. In order to compensate for these risks, streams of rental income per dollar of real estate thus tend to be greater than the returns derived from ‘risk free’ assets. Ownership of businesses and corporate bonds tend to be riskier still because (ignoring the extent to which the cumulative effects of inflation constitute default by stealth) a business is far more likely to fail than the Commonwealth Government is to default on its financial obligations; further, the ability of businesses to generate earnings and make interest payments are most variable, least predictable and least assured. Again, in order to compensate for these additional risks investors demand a larger stream of earnings per dollar invested.

It is therefore imperative that shareholders confront squarely several unpleasant possibilities. These include the possibility that a permanent loss of capital may occur; it also includes the potential extent of any such loss. It is also vital that shareholders understand Leithner & Co.’s basic approach to uncertainty and risk, and that they be able to cope with that uncertainty and risk. (A detailed justification of Leithner & Co.’s approach to investment risk management is set out in a four-part circular to shareholders entitled “Value Investing, Risk and Risk Management.” First principles are set out in Part I; they are assembled into a simple framework in Part II; this framework is illustrated with examples in Part III; and these examples’ implications are discussed and elaborated in Part IV).

1: What Is Risk?

2: Coping With Risk: Investor Temperament and ‘Mr Market’

3: An Unheralded but Significant Risk

What Is Risk?

Benjamin Graham (founder of modern securities analysis and the ‘value’ approach to investing) and Warren Buffett (Graham’s most celebrated student and America’s most outstanding investor) emphasise that the keys to successful investing are the identification of excellent businesses, the determination of their intrinsic values and the payment of bargain prices (see Investment Philosophy and Principles). Successful investing is easier to describe than to undertake. This is primarily because it requires that one make assumptions about companies and their prospects (see, for example, the circulars to shareholders entitled ‘Irrational Exuberance’ in Australia and Reasoned Scepticism Versus Irrational Exuberance). These assumptions are fraught with error and uncertainty; accordingly, risk (i.e., the likelihood that certain desired events do not occur, or that undesirable events actually do occur) unavoidably accompanies any investment operation.

For a Graham-style value investor, four sets of risks are most noteworthy:

1. the possibility that a good (on the basis of its past and current operations) business ceases in the future to be a good business;
   
   
2. the possibility that an unreasonably high price is paid for a good business (or that the purchaser makes unduly optimistic assumptions about its prospects);
   
   
3. the possibility (perhaps as a result of mistaken or insufficiently thorough research) that what the investor believes to be a good business is actually a mediocre or poor one;
   
   
4. the possibility that widely-accepted fallacies and falsehoods are received as facts.

Two corollaries follow from these points. First, risk has as much to do with the attitude, disposition and behaviour of the investor as it has with the characteristics of the investment. Second, something that is cited very frequently as a risk to investors, the short-term (i.e., day-to-day, week-to-week and month-to-month) volatility of market prices, is in actual fact not a risk. Quite the contrary: if understood properly, short-term price volatility presents great opportunities – and long-term volatility presents significant dangers – to investors.

Coping With Risk: Investor Temperament and ‘Mr Market’

In order to appreciate these corollaries it is useful to recount a key distinction drawn by Graham: the basic difference between value investors and speculators lies in their attitude towards current market prices. The speculator regards the value and the market price of his securities as synonyms and tries to anticipate and profit from short-term fluctuations in market prices. In contrast, the value investor draws a clear distinction between current market price and intrinsic value and pays attention to prices and short-term price volatility only to the extent that they enable him to acquire the securities of good companies at reasonable or bargain prices. According to Graham, value investors bear this distinction constantly in mind and therefore possess a distinct temperament. More generally, and whatever their mathematical, financial and accounting abilities, Graham observed that individuals who cannot master their emotions seldom invest successfully.

Graham used a simple allegory to explain these points. Imagine that you and a good friend, ‘Mr Market,’ are partners in a private business. Each day, without fail, Mr Market quotes to you a price at which he is willing either to buy your interest or to sell his to you. The business has stable and favourable economic characteristics. Mr Market’s quotations, however, are anything but stable. On some days his quotes seem to be justifiable in light of your business’s characteristics and a reasoned assessment of its prospects. On other days, however, he is exuberant about the business and can see only sunshine and smooth sailing ahead. On these days, fearing that you will try to snap up his interest and deprive him of imminent and substantial gains, he insists upon a very high price for his share of the business. Seemingly without rhyme or reason, however, on yet other days Mr Market is despondent about the business and its prospects. Seeing nothing but storms and rough seas ahead, and fearing that you will attempt to unload your interest in such an apparently poor business upon him, on these days he quotes a very low price.

For all his instability and possible irrationality, Mr Market has a very useful characteristic: he takes no offence if you ignore him. Transactions are solely at your discretion and if you snub him today, no problem – he will return tomorrow with a fresh quote. If you are a prudent investor-businessman (Graham regards the two terms as synonyms), will you let Mr Market’s daily quotations determine your estimate of the business’s intrinsic worth? Hardly. But notice that the more manic-depressive his behaviour – and hence the more volatile his quotes – the greater the opportunities which he presents to you. Clearly, you will be happy to sell to him when he quotes to you a ridiculously high price, and you will be equally happy to buy from him when he quotes a foolishly low price.

The moral of this parable is clear: the prudent investor-business owner must remain detached from Mr Market’s erratic and sometimes manic-depressive gyrations, form his own ideas and conduct his own analyses based upon critical scrutiny of hard financial data from company reports and other credible sources.

It is vital that Leithner & Co.’s shareholders appreciate the full importance of this implication, for it forms a cornerstone of the Company’s investment operations. Graham warned his students that it is Mr Market’s pocketbook – but not his ‘wisdom’ – which is useful. Mr Market exists to serve rather than to guide investors. If he is in one of his moods and quotes a foolish price, investors are free either to ignore him or to take advantage of him; but disaster will ensue if they fall under his influence.

An Unheralded But Significant Risk

To a Graham-style value investor, then, the short-term (i.e., day-to-day, week-to-week, month-to-month) volatility of a particular security’s market price does not constitute a risk. In sharp contrast, the possibility that the mood of Mr Market becomes depressed for extended (i.e., multi-year) periods, significantly decreasing the prices of most securities, is a significant risk for Leithner & Co. and indeed all shareholders. Mr Buffett, in a series of speeches published in Fortune magazine in November 1999, outlines why he believes that many of today’s ‘investments’ are riskier propositions than their owners realise and why investors should reduce their expectations about future rewards.

Austin Donnelly, doyen of the financial advice industry in Australia, regards the possibility of long-term market decline as the most significant risk facing investors. This risk, according to Donnelly, is seldom recognised fully or disclosed properly. Donnelly notes that during the five-year period beginning in September 1987, losses of at least 30% were commonly incurred. In his view, a decline of 20% in stock prices over a 10-year period is a distinct possibility at any time; moreover, given the tendency of investment returns to revert to a long-term mean, this possibility is considerably higher when (as is the case at the moment) prices have risen appreciably for many years.

Leithner & Co. shareholders, like shareholders in any company, need therefore to recognise the long-term risk which attaches to any investment:

• periodic slumps have caused losses of 40% or more, with recovery taking up to 10 years;over five-year periods, price changes have varied dramatically (from a gain of 330% gain to a loss of 55%);
  
  
• in Australia there have been periods of up to 15 years (and in the U.S. there have been periods as recent as 1965-83) during which market indices have recorded no inflation-adjusted net gains.

Austin Donnelly contends, and I agree, that there exists a marked gap in Australia between investment markets and reality. In his view, a great deal of the conventional wisdom about investment in this country is based more upon fables, fallacies and folklore than reality. Most importantly, it is erroneous to think that price declines are always short-term affairs, and that prices have moved and will therefore continue to move inexorably upwards over long periods. The reality, according to Donnelly, is quite different. Slumps have occurred after major booms; and market prices have taken up to ten years to recover from some slumps. There have also been periods of up to fifteen years during which no sustained gains have occurred. Donnelly therefore concludes that, to be assured of a reasonable return on an investment, a much longer time horizon than is usually recognised – no less than 15-18 years – is necessary.

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