Risk is a heavyweight word, particularly for investors. For some, risk means an investment might not achieve the return they desire. While such thinking is not wrong, from a core investment perspective, we see risk as many of our clients do: The potential permanent loss of capital. How you "live" with risk varies according to your vantage point.
The personal financial and economic risks taken by entrepreneurs (borrowers) are the lifeblood of a vibrant economy and promote efficient allocation of capital and, ultimately, a higher standard of living. Small- to large-scale companies raise money by borrowing from investors through the sale of equities or bonds. As lenders, investors see risk as a four-letter word, taking steps to avoid and/or manage the "risky" aspects of transactions. Stripping risk to its primary elements, we know:
- There is risk in every transaction between borrower and lender.
- The starting point for assessing risk is the economic realities of the borrower and their fundamentals, which articulate the ability to generate income at a given time.
- The price of a stock or bond is currently the market's main means of communicating the riskiness of an asset. Using equities as an example, the rise and fall of a stock price reflects how much the investing public wants to be compensated for assuming the risk it associates (whether real or not) with a company.
- When the price rises or falls, the potential return for investors moves in the opposite direction. This continues until conditions eventually re-normalize to an area closer to their true "value." Logically, price signals should make it easy to "buy low and sell high." In other words, when things look too good, and prices are far higher than the actual value of an investment, then risk is high as the likelihood of the true value and cash flows growing fast enough to justify the lofty price is slim. When share prices are very low, the reverse can be true and there is the opportunity to grow your money over the long term.
- Research shows stock prices are 19x more volatile than the stream of earnings used to calculate the fair value of the underlying businesses.¹ What is a primary driver of volatility? Investor emotion or sentiment, which has been hyperactive over the last several years. Sentiment tends to dictate that as prices move lower and assets move from an overvalued to an undervalued status, the perception of risk increases, making it difficult to invest in something that is not "doing well." In fact, with quality research and analysis and a long-term view, our experience shows opportunities stand in the shadows of pessimism.
For some time now, we have seen investor sentiment trump fundamentals as evidenced in the story prices tell.
For example, look at the facts surrounding global government bonds, the world's largest asset class:
- Central banks in the world's largest economic zones have been taking positions in sovereign bond markets, as a means of lowering interest rates in order to reduce the debt service burden of their governments and/or roll over existing obligations to other creditors.
- In many major economies, nominal inflation is higher than the nominal bond yield. As a result, by investing in some fixed income securities, one locks in rates of return that destroy purchasing power over the long term.
- Looking at fixed income market prices, at first glance you see a very comforting upward slope. However, these arguably distorted pricing signals are encouraging money to continue to pour into these securities, pushing prices higher and yields lower.
We believe current conditions are much closer to the "sell high" part of the fixed income cycle than the "buy low" and it is time to begin reducing our clients' risk. This view is reflected in our latest asset allocation strategy. Conversely, equities in some sectors and regions are currently sitting on the low end of the teeter-totter, weighed down by sentiment ignoring the true value of the business and the lower risk, long-term opportunity. We are not recommending isolating one asset class over the other. We are saying, though not always the most comfortable position, it is critical to appreciate the logic amid the noise.
The above Index reviews are calculated from external sources and, where applicable, reflect total returns.
All figures are in Canadian dollars and are as of June 30, 2012.
(1) 1) Jeremy Grantham,"My Sister's Pension Assets and Agency Problems," GMO Quarterly Letter, April 2012.