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A Conversation About Risk and Reward

This last week had Q2 earnings season kicking off in earnest and one of the big stories, aside from Anthony Scaramucci, has been tech. Google, Amazon and Facebook all reported this week – Google and Amazon missed expectations and dropped.

Research analysts are reciting the same lines about tech stocks being a crowded trade and talking heads are talking about stretched valuations. This brings me back – to another time when I thought that General Electric was a better purchase than Google.

Rewind 40 years ago and I am in the prestigious Trinity College of the University of Cambridge Toronto having a conversation with my then-significant other in Robarts Library.

I don’t recall, precisely, what it was that was so alluring about her (far easier to remember what was alluring about me) but I distinctly remember bright teal New Balance shoes, carrot-dyed hair and a Chrome-Pink Bentley and I suspect it was probably the car – so gauche and yet so enticing.

“Hey, so this guy confessed to me today.”

“Confessed to what? Are you a cop?”

“No, he confessed that he had feelings for me.”

“I didn’t know that was a thing. Why didn’t he just ask you out?”

“That’s too direct. Anyway, I told him about you and he became really upset – he said I was superficial because I chose you just because you go to Rotman while he is at George Brown. He says he is just as smart as you and that he took all his savings, in addition to borrowing $50,000 from his parents, and put it into the stock market. He says in 20 years he will come out on top and then we will consummate our affection. He said he bought NVDA, GOOG, AAPL and AMZN.”

Hailing from the cultural capital of Newmarket, Ontario, I was perplexed by the roundabout and ineffective way that he was hitting on my girlfriend, so I made it incumbent upon myself to educate her with everything that I had learned from 1) life and 2) class.

  1. If he asked you out 3 months earlier maybe you two would be dating instead of making subtle, unintelligible advances – also he wears a Nike tracksuit every day, spends most of his time in a pool hall or playing DotA, has a diet of instant Kimchi noodles (unlike my alpha diet of whey protein and hard-boiled eggs) – in fairness, I give him 10 points because he drives a Lexus (that his father purchased) with new lights (that his father purchased)
  2. He is so remarkably foolish and taking on undue downside risk because asset prices are overvalued right now from accommodative monetary policy and high beta stocks are most vulnerable to the inevitable correction in equities

How did I know this? Because in my preparation for investment banking interviews, I knew to adhere to semi-strong market efficiency and the capital asset pricing model (CAPM). Instead, I spent time educating SO on how Power Financial was a low-volatility stock well positioned for a rising rate environment.

He also bought a pre-sale apartment in the Financial District.

“That’s even more foolish, as a multiple of income, housing in Canada broadly and specifically in Toronto is extremely overvalued and bubbly.”

Anyway, needless to say I was wrong because Power Financial is still at $34 and Google/Alphabet, Amazon, the graphics card company and Amazon have quintupled since then. Real estate has also become more bubbly. Our relationship has since dissolved and she ended up marrying that guy she told me not to worry about at the Shangri-La in Kuala Lumpur.

Hindsight is 20/20 so here are some observations.

Historical Volatility as Risk is a Flawed Construct

The intrinsic value of asset prices is based on the discounted value of its future cash flows. Accordingly, picking the appropriate discount rate is paramount.

In academic and for all intents and purposes, the majority of practical valuation is based on a weighted average cost of capital that is based on an incorrect return on equity. As such, the discount rate is inherently flawed because the return on equity is calculated via a regression of historical movements versus the broader market.

One major problem is that this reflects absolute movements without regard to upside or downside. If Google/Alphabet moves up 3% every time the market moves up 1% and moves down 0.5% every time the market moves down 1%, this will result in a strong relationship and a high beta, but nothing to suggest that Google carries more risk than the average investment.

Fundamentally, an investor also must identify what risk inherently is – risk is not volatility, risk is the potential for loss. Risk should be framed as what an investor can afford to lose.

That Google has historically moved (primarily to the upside) in a more pronounced manner versus the rest of the market does not take away from the strength of its business model and the competitive moat it enjoys as the world’s leading search engine and advertising machine.

Outside of Deep Value, Cheap is not Good and Good is not Cheap

Despite my thesis for PWF, which made sense – it was not an original idea and it was one which was already reflected in the stock. PWF was not mispriced, so the potential for appreciation was limited.

Deep value is predicated on purchasing an asset at a significant discount to intrinsic or realizable value. A fairly large-cap, institutional favorite such as PWF is likely to have a wide array of eyes on where the price should be.

Investing to generate alpha (to beat the market) is not easy, otherwise everyone would be doing it. To do it well is a full-time job. My full-time job was in investment banking (which, as many people do not know, has very little to do with investing) and accordingly I was not in a position to know where PWF should have been.

Just looking at a price/earnings ratio or other standard multiple for Google and thinking 40x is too high versus the market average of 12x ignores expected growth. Assuming that multiples do not contract (a different discussion), if earnings grow by 20%, then the stock will grow by 20%.

In that sense, an evaluation of other factors beyond earnings multiples such as return on invested capital and qualitative factors such as recent initiatives can guide an investor to think that there is a lot of value in Google.

Buy What You Know While Cognizant of Value

A sound business is not necessarily a sound investment. Google was a good stock during the time of the story and arguably, Google is still a good investment due to its positioning for the secular trends of tomorrow in the Internet of Things, healthcare and artificial intelligence. However, Google’s value is independent of whether the stock trades at $1 or $4,000 – price is what you pay, and value is what you get.

That said no one can assign a price ceiling for Google without knowing the value, and no one can know the value without knowing the business.

When making an investment decision, I knew the business of Google (to some extent) and used all of Google’s products.

I knew multiples for PWF but did not understand insurance, nor their convoluted accounting incorporating all sorts of magic around proportionate consolidation and off-balance sheet items. In addition to that, no one really understands insurance.

Ultimately, I had much more business buying Google than buying PWF.

Leverage is a Double-Edged Sword

As a staple of private equity firms, using other people’s money with a cost of carry lower than the yield from your investment magnifies returns. When the asset you are betting on is falling, leverage magnifies loss.

As alluded to above, risk is not volatility – risk is the probability of loss and the magnitude of loss. As such, with a greater magnitude of loss, leverage is risky. Leverage enhanced the earnings for the tech portfolio that landed a wedding and a few more properties, but leverage cuts both ways.

This is the one area where the hero of our story (me being a villain) took a bet which happened to work out well. If the market turned due to macroeconomic reasons leading to a flight to safety, he would have been destitute and compromised his family’s financial welfare – even if Google was fundamentally sound. This ties back to…

Market Timing is Paramount, Yet Impossible

There is a lot of inertia behind market movements and in this instance, the hero of our story got to ride the momentum of a much bigger wave. Timing the market correctly has tremendous ramifications for the performance of an asset portfolio – however no one can consistently time the market.

The NASDAQ is a great benchmark for technology in general, and since inception it has been one of the most profitable bets for an investor who has made periodic purchases of the index and its surviving components over a long-time horizon. However, it should be noted that the NASDAQ has only recently surpassed its tech bubble top back at the turn of the millennium.

Choosing to stay out of the market because of Case-Shiller or some other macroeconomic indicator is stupid and not only deviates from a good value philosophy, but also deviates from the reality that equities have consistently outperformed bonds and definitely savings accounts because of the risks and rewards of ownership.

Over a long enough time horizon, being in the market is a positive-sum game – staying out can keep you safe from a correction, but staying out also keeps you from earning a return on your hard earned money. As Matt Damon says, “you can’t lose what you don’t put in the middle – but you can’t win much either.”

Despite the folly of market timing, volatility can be muted if investing is averaged over time. Younger professionals have ample human capital that is paid out ahead of them – assuming the cash flows from a salary keep coming, a falling market means that good assets are getting cheaper. Should they be fundamentally sound assets, this means a bigger profit on the future revaluation. If stocks just keep going up… well, great.

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Matt
ex investment banking associate
https://www.linkedin.com/in/matt-walker-ssh/

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