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To Finish First, First You Must Finish

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Our professors and partners have come from as far away as Australia to contribute their wisdom and guidance. Throughout the next two days we will be highlighting some of their ideas on managing risk and staying in the game as catalysts for discussion.

Approach:

- To finish first, first you must finish. Thus looking down (for risk) often is more important than looking up (for return). In a long only portfolio there are three interrelated pillars to risk management: diversification, stock selection, and valuation.
- Diversification - risk reduction doesn't need to lead to subsequent reduction in return. Stress testing a portfolio for probable risks exposes weakness if a potential problem becomes a reality.

- Stock selection and Valuation - we look for three things in every stock: Quality, Value, and Growth.

- Quality - Companies don't operate in a competitive vacuum; as such even the most successful will stumble at some point. The (quality) strong will get up and re-group to move forward, weaker ones may not. These are the characteristics that define high quality companies:

- Sustainable competitive advantages
- Predictable earnings
- Significant free cash flows (operating cash flows less capital expenditures)
- High return on capital and economic value added returns far exceeding the cost of capital (value creation)
- Strong balance sheet

Valuation - we utilize a multi-prong approach to determine appropriate valuations.

- Discounted cash flows - direction of value; highlight key company drivers

-Relative valuations - to peers and historical valuations

- Absolute valuation metrics - P/E, price to operating cash flows, price to free cash flows

- Margin of safety - critically important as room for disappointment. It is only a matter of time before even the best company will disappoint Wall Street. However, a company that trades at a discount to its 'appropriate' valuation (margin of safety) is likely to respond less violently to the disappointment.

- Growth - we have a very long-term perspective, so often we don't know when the market will fall in love with our companies. If companies have grown their earnings, our patience will be compensated when the love affair resumes.

Key Themes:

- Substantial slowdown in the Chinese economy and its impact on demand for U.S. products.

- Rise or fall of oil prices - our portfolios are positioned mostly to benefit from the likelihood of long-term decline in oil prices. We have some exposure to oil stocks as a hedge in case oil prices climb further or stay high.

- U.S. housing bubble imploding and its impact on consumer discretionary spending or/and rising interest rates and their impact on the overleveraged U.S. consumer, we are limiting our exposure to consumer discretionary stocks.

- U.S. trade deficit causing a further decline in the U.S. dollar - we added some high quality, very high yielding European ADR's to mitigate that risk.

Outlook for the financial markets:

-Investors will be paying for the excesses of the last bull market for a long time. We expect the stock market to go nowhere with plenty of volatility and micro bear and bull markets in the interim. This market will require some fine-tuning to the investment strategy for even a long-term investor.

Thoughts on controlling risk and staying in the game

"The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us."
-- Peter Bernstein


If I could give one piece of advice to attendees...

- Understand the companies in your portfolio - understand the drivers of growth and the risks inherent in the business. If you don't understand it don't buy it (show me an investor who understood Enron).

- Do your own research - don't simply rely on somebody else's advice.

- Write, write, write - write down your rationale for making an investment decision. And clearly highlight your reasons for buying the stock in the first place. Keeping to this rationale will help you keep your emotions in check.



No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

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