How To Manage Permanent Loss Of Capital

Today, we ask the question is How To Manage Permanent Loss of Capital?

Jason here with a quick note…

The following is a guest post from H.C. Eu over at the value investing blog Investing for Value.

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He’s a great value investor from Malaysia that I’ve followed for years now.  His analysis is great, detailed, and informative so a while back I asked if he’d like to do a guest post here on the Value Investing Journey site.

Here is his third – of hopefully many – guest posts here on this site.  And if you love this analysis as I know you will make sure to check out his site at either the link above or those further below at the end of the analysis.

Also, make sure to show H.C. Eu some love in the comments below or once this hits our social media pages as well.

Now, I’ll let H.C. take it away with his article on How To Manage Permanent Loss of Capital.

I hope you enjoy it.

Always in your service,

Jason Rivera.

***

As a value investor, you would have been told that volatility is not risk. Rather you should consider risk as a permanent loss of capital.

With such a perspective, you don’t’ have to bother with Beta, standard deviation, Sharpe ratio and all other risk metrics that are based on volatility.

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If you do this, how then do you assess and manage risk?

There are lots of resources about what is value investing, how to analyse companies and how to value them. But there are hardly any resources on how to assess and manage risk from a permanent loss of capital perspective.

Sure, there are lots of materials on managing risk as volatility. But you are left on your own when it comes to permanent loss of capital.

I faced the same challenge years ago when I first started to learn about value investing. At the end of the day, I had to tap into my corporate risk management experience to come up with an investment risk management framework.

In this post I will share with you this framework covering:

  1. Key concepts from corporate risk management.
  2. Identifying the root causes.
  3. Assessing the risks.
  4. Risk mitigation.
  5. Summary.

1. Key concepts from corporate risk management

In the corporate world, risk management is considered a discipline by itself. The discipline has evolved over the years and became more widespread with the growth of corporate governance.

According to the Corporate Finance Institute, risk management encompasses the identification, analysis, and response to risk factors that form part of the life of a business.

Leaving out the corporate jargon, the risk management process involves the following steps:

  • Identify the causes that can lead to the risk.
  • Assess the impact and the likelihood of the occurrence.
  • Adopt mitigation measure to manage the risk.
The risk mitigation measures you adopt will of course depend on your own situation. In general, there are 4 strategies to manage risk. They are
  • Avoidance – what can be done to prevent it from happening.
  • Reduction – how to minimize the impact of any risks?
  • Acceptance – in some instances where the cost of mitigation outweighs the benefit of the mitigation strategies, it may be better to live with the risk.
  • Transfer – is there a way to transfer the risk and/or the consequences to another party?
If you consider the permanent loss of capital as risk, there is no reason why you cannot use the corporate risk management framework to manage risk.

2. Identifying the root causes

It is obvious that identifying all the causes of investment risks is critical. When I first started to think about risk, I spent a lot of time researching investment risk literature. I wanted to produce a universal list of investment risks.

It is very sad to say that there is a lot of muddled thinking out there.

For example, I have come across an article that described 4 ways to mitigate risks. It then went on to cover diversifying into different sectors, countries, market capitalization and styles. To me these all covered only one mitigation measure ie diversification.

Many people also confuse between cause and effect. Some of the recommended risk strategies don’t address the root causes.

I spent my early work life as a manufacturing engineer with quality management as a key role. I learned the meaning of cause and effect.

If a particular activity was the cause of a defect, once you stopped the activity the defect should go away. If the defect still persists, then that activity is not the cause. You then have to dig deeper as what you thought was “a cause” was actually “an effect”.

This is where the Ishikawa or fishbone diagram came in.

2.1 Ishikawa diagram

An Ishikawa diagram shows the causes of an outcome and is often used in manufacturing to show where quality control issues might arise.

It is sometimes referred to as a fishbone diagram. It resembles a fish skeleton, with the “ribs” representing the causes and the final outcome appearing at the head of the skeleton. In such a diagram:

  • The head of the fish is created by listing the problem and drawing a box around it.
  • A horizontal arrow is then drawn across the page with an arrow pointing to the head, this acts as the backbone of the fish.
  • The key causes are identified that might contribute to the problem. These causes are then drawn to branch off from the backbone with arrows, making the first bones of the fish.
  • For each key cause, the root causes of the problem are identified. These contributing factors are written down to branch off their corresponding key cause.
  • The chart below shows the structure of an Ishikawa diagram.
chart
2.2 Possible causes of permanent loss of capital

I used the Ishikawa diagram to identify the investment risks.

To suffer a permanent loss of capital, the investment has to be sold at a price that is lower than the buying price. For simplicity, I will ignore the situation where the investment has been sold due to short-term volatility. From a value investment perspective, this is unlikely to happen.

Rather I assumed that any loss is because the price is “permanently” below the purchased price due to the following direct reasons:

  • Deterioration in the intrinsic value due to changes in the fundamentals.
  • Issues with portfolio construction.
  • Wrong assessment of intrinsic value in the first place.
  • Stock market changes.
These are the main direct causes and there are other root causes for each of them.
To help identify the root causes, I used the Ishikawa fishbone diagram with the results as shown below.
chart2

I would hasten to add that you may have your own way to frame the various cause-and-effect. The point is not to debate who has the better fishbone.

The fishbone diagram is a means and not the end. The most important thing is that it provides you with a framework to think about the risks.

An explanation of each of the root causes for the boxed items in my Ishikawa diagram are presented below.

2.2.1 Deterioration of intrinsic value
The intrinsic value of a company could decline over time. Over the long term, the market price will decline to reflect this. I have identified 3 root causes for this.
  • Management could be the cause of the decline. This could be adopting the wrong strategy or plain incompetence.
  • Financials – if the company has debt, there could be changes to the loan situation eg higher interest rates that affect its profitability or cash flow.
  • External – this covers all the social, political and economic changes that negatively impact the company. I would include technological changes here as well.
2.2.2 Portfolio construction
It is unlikely that you would invest in one stock. Rather you would have a portfolio and you could suffer a permanent loss of capital due to portfolio construction and management issues. I have identified the 3 common issues:
  • Position size. This relates to the number of stocks in the portfolio and the amount to be allocated to each stock.
  • Cash management. From an individual investor perspective, the amount of cash you hold affects your holding power. You should have enough to handle emergencies without being forced to sell your shares at the wrong time.
  • Hedging refers to other strategies of guarding against risk eg taking a short position
2.2.3 Wrong initial intrinsic value
The assessment of intrinsic value is the heart of value investing. If this was wrongly assessed at the start, the purchase would be a mistake.
  • Governance. The intrinsic value is generally assessed based on the financial statements. If there are issues due to the poor quality of earning or even creative accounting, the computed intrinsic value would be wrong.
  • You could have made some analytical errors in assessing the intrinsic value. You are more likely to make errors if a company has a complex business model.
  • Your behavioural biases can skew your estimates of intrinsic value.
2.2.4 Stock Market Changes
This is based on my personal experience where I suffered a permanent loss of capital due to regulatory type of issues.
  • Privatization – you are sometimes forced to sell at below your purchased price due to a privatization/corporate exercise.
  • Regulatory – these relate to rules that affect the availability of the stock eg trading restrictions. There is a “feedback loop” here. If the business deteriorates there is a higher likelihood of some listing guidelines that may affect its liquidity.

The above Ishikawa diagram shows the first level cause-and-effect. You can have a second or even third level cause-and-effect diagram for the more complex cases.

For example, in the case of the External factors, you could further break it down into

  • Different economic factors eg interest rate, GDP growth, inflation.
  • Different social factors eg demographic trends, migration patterns.
The key thing is that you must be able to link a cause to the permanent loss of capital. If cannot describe how it can result in a permanent loss of capital, it has not place in the Ishikawa diagram.

3. Assessing the risks

The goal of risk assessment is to evaluate the likelihood of occurrence of each of the causes/threats and their impacts.

One corporate risk management approach is to set up a Threat matrix as shown below. You then classify each risk into one of the following 4 coloured cells based on:

  • The assessment of its impact. Think of the impact as the amount of permanent capital lost.
  • The likelihood of it occurring.

It is important to be able to slot the various causes into the appropriate cells of the Threat Matrix as it helps to determine your mitigation measures.

Determining the likelihood of the cause is a judgement call based on your own investing experience. Over my past 15 years of value investing, there have been several occasions where I have suffered a permanent loss of capital.

  • Once or twice, my whole investment was wiped out because the companies went into liquidation following some fraudulent practices.
  • I have sold stocks incurring some losses after waiting 10 years for the market to re-rate. Actually, I lost patience.

I have then my used this experience to classify the various causes into “high” or “low” probability ones. If you don’t’ have sufficient experience with bad investments, I would suggest that you play safe and classify a cause as “high probability” if you are not sure.

When it comes to assessing the impact, I think along the following lines.

  • If it impacts the whole portfolio, I classify it as “high impact”
  • If it affects a single stock, then I look at the consequences. If it can wipe out the whole investment, I classify it as ‘high impact”. If it only reduces a small % of the investment, I classify it as “low impact”.

For example, I would consider a deterioration in the intrinsic value due to poor management as a “high impact” one.

For my investment process, the following fall into the red cells

  • Deterioration in the intrinsic value – poor management
  • Wrong initial intrinsic value – behavioural
  • Stock market changes – privatization

The idea of slotting the various risk into the 4 cells is because it will help you identify the risk mitigation measures.

Remember the 4 mitigation measures – Avoid, Reduce, Accept and Transfer?

There are costs associated with each of these mitigation measures so it is important to have an idea of which cell a particular risk falls into. Generally

  • I would “Accept” the risks that fall into the green cell
  • I would “Avoid” or “Transfer” the risks that fall into the red cell
  • I would “Reduce” or “Transfer” the risks that fall into the orange cell
  • I am ambivalent on what to do when it comes to the yellow cell

4. Risk mitigation

Once you have identified and assessed the risks, you can then formulate the appropriate measures to mitigate the risks.

Some of the common measures include

  • Diversification
  • Having a margin of safety
  • Having a Standard Operating Procedure or SOP to reduce behavioural biases
  • Stay within your circle of competence
  • Be conservative

I have a post in my blog with a comprehensive list of risk mitigation measures. You can refer to “How To Mitigate Risks When Value Investing”

The challenge is not just formulating the measures. You have to ensure that you address all the causes that have been identified in the Ishikawa diagram. To do this, I have what I call the Risk Mitigation Matrix.

Conceptually, think of a matrix where each row represents a particular cause of a permanent loss of capital. Then each column in the matrix represents each of the mitigation strategies – Avoid, Reduce, Accept and Transfer.

You then look at each of the causes and figure out the best risk mitigation strategies. Best in my context means:

  • It can effectively or comprehensively address the cause.
  • The cost of implementing the strategy is something bearable. I have judged that the benefits outweigh the costs.
  • It applies to several risk causes.

Furthermore, if you view risk as a function of both the likelihood of the cause and the impact, then depending on the nature of the risk

  • Some of the measures focus on the likelihood.
  • Some focus on the impact.
  • Some cover both likelihood and impact.
4.1 My Risk Mitigation Matrix

The chart below summarizes my risk mitigation measures in the Risk Mitigation Matrix format.

The thing that is missing from that chart is the “Transfer” measures. This is because it applies to all the causes. To transfer some of the risks, I have some of my net worth invested in unit trusts and properties. These have a different risk profile than those of stocks.

There are also some empty cells in my Risk Mitigation Matrix. This is because I could not formulate an appropriate risk mitigation measure.

Furthermore, remember the Threat Matrix? For those risks that fall into the red cell, you should not have any blank cell in the Risk Mitigation Matrix.

Accordingly, if you look at my Risk Mitigation Matrix, you will see that there are measures in all the related cells. In fact, there are more than one measure for some of them.

chart 4

Notes on some terms in the Risk Mitigation Matrix

a) Cost-benefit – only hedge if the benefits outweigh the cost

b) Don’t rush – this refers to slowly building up or exiting a position.

c) 3 Bucket – this is part of my asset allocation measures where I divided my net worth into 3 Buckets – liquid assets., safe assets and risky assets. If you want to know more search my article “Baby steps in Asset Allocation for a Value Investor”.

The focus of this post is not to discuss specific risk mitigation measures. Some of the risk mitigation measures eg margin of safety will require its own post to cover it comprehensively.

Rather my goal is to ensure that you have a way to identify the root causes and have formulated an appropriate measure to mitigate the risks. There should never be a cause with a corresponding mitigation measure.

5. Summary

Risk management involves identifying the threats, assessing, and then mitigating them. I have presented a risk management framework comprising of several elements.

  • The Ishikawa diagram to identify the root causes of a permanent loss of capital.
  • A Threat Matrix to assess the likelihood and impact of each of the risks. You consider both the likelihood of the risk happening and its impact.
  • A Risk Mitigation Matrix to ensure that we have measures to mitigate each root cause. The mitigation measures involved avoiding, reducing, accepting, and transferring the risk.

I hoped I have shown you how to tie all the various elements of the risk management framework together. How have I used the framework?

I am sure you will find your own uses.

***

Is Steel Dynamics a growth trap?

Editor’s Note: The article is from H.C. Eu who blogs at Investing for Value. He is a self-taught value investor and has been investing in Bursa Malaysia and SGX companies for more than 15 years. His value investment experience has been enhanced by both his Board experiences and his contacts with controlling shareholders of many Bursa-listed companies. These have given him a unique opportunity to be able to analyze and value companies differently from other research houses.  If you enjoyed this piece, you can find similar pieces and other value investing tips in his blog.

H.C. Eu is not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured company.   Investments or strategies mentioned may not be suitable for you and you should have your own independent decision regarding them. The opinions expressed here are based on information he considers reliable but he does not warrant its completeness or accuracy and should not be relied on as such. He does not have any equity interests in the company featured.

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