How much business risk are you taking in your portfolio?
An ownership mentality is critical to success but many investors ignore the risk of the businesses in their portfolio.
Mentioned: Alphabet Inc (GOOGL)
We hear a lot about risk in the investment world. The investment industry defines risk as volatility and measures such as beta and standard deviation are used to denote the risk of an individual security and a portfolio.
For most investors volatility matters little over the short-term. A focus on volatility can lead to poor decision making as the gyrations of the market can cause investors to act against their own long-term interests.
As shareholders we are owners of a business. An ownership mindset provides a ballast to share price movements that may not reflect the long-term prospects of the underlying business. Instead of focusing on volatility, concentrating on the business risk inherent in each company we own may be a better approach for long-term investors.
The value of any company is the future cash flows that the company generates. These cash flows can be used to fund expansion, pay down debt and reward shareholders with dividends and buybacks. That is what matters. Share prices are driven over the long-term by differences between expectations for future cash flows and what is generated.
Therefore, logic dictates that the inherent risk of any business is the predictability of the cash flows that will be generated by the company in the future. The factors that influence future cash flows vary by business.
Some businesses have a wide-range of factors that influence their future cash flows. Some in their control and many outside of their control. The economic climate, the factors that influence pricing, consumer tastes and the actions of competitors may be uncontrollable influences on a business.
Debt gets sold as an enabler of choice. In reality, for both individuals and businesses, it is a limiter of future options. Too much debt can limit the way a company can respond to an unexpected crisis. Too much debt can mean a company is unable to respond to opportunities that are unexpectedly presented.
The future pathway of some companies are more predictable. For those companies maintaining a moderate level of management competence is all that is needed to stay on the right path. As Warren Buffett famously said, “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”
How business risk impacts a company
A company with a wide range of factors that influences how they will perform in the future has a wider range of potential outcomes. Especially if many of these factors are outside of the company’s control. The future cash flows that are generated are less predictable.
If everything goes right buying shares in that company could be enormously profitable. If even a couple things go wrong that same company could go out of business and an investor could lose their entire investment.
In retrospect outcomes appear to be inevitable. In reality they are anything but predictable. In 1996 two PHD students at Stanford University named Larry Page and Sergey Brin started a research project on creating a better internet search engine. At the time the market was fairly fragmented with AltaVista controlling around a quarter of internet searches. Excite followed with a 15% market share, Lycos at 12% and Yahoo at 8%.
The company Google (NAS: GOOGL) was founded in 1998 based on the results of this research project. At the time the internet search market share was starting to concentrate with AltaVista, Lycos and Yahoo handling 50% of total searches.
At the turn of the millennium Google was starting to make their mark with just over a 10% share of total searches. Yahoo was now the clear leader with a 20% share but the new entrant by software giant Microsoft called MSN had been gaining ground and held a 12.5% share. By 2003 Google had taken over the number 1 ranking by pulling just ahead of Yahoo, MSN and AOL.
In 2007 Google hit 50% market share and from there they consolidated their position as the number 1 search engine and now make up roughly 83% of internet search volume despite not operating in China.
This incredible journey was far from pre-ordained. There were thousands of factors that led to this rise. Smart decisions by Google, poor decisions by better funded rivals and shifts in the way that consumers purchased and researched products and companies marketed them.
Shifts in the way that governments approached anti-trust provisions abetted this rise with little initial concern about Google’s growing market power. The availability and scale of funding from private and public investors facilitated their growth. The decision by founders Larry Page and Sergey Brin to put their egos aside and hire an experienced CEO in 2001 assuaged the investor community and led them on a pathway to going public in 2004.
Throughout this early period the range of outcomes for Google were immense. To get from a research study to one of the largest companies in the world took a lot of skill and a lot of luck. It took the efforts of countless individuals, governments, and companies to create the internet as we know it today. It took a shift in the behaviour of billions of people around the world.
Was creating a better search engine a key factor of this growth? Of course. But history is littered with better products that didn’t make it. That didn’t come around at the right time. That didn’t have the external factors that facilitated growth to a dominate position. Better products that were sabotaged by poor decision making and bad luck.
A $1000 investment in Google when it went public roughly 20 years ago would result in a position worth $58,180 today. It could have easily been worth nothing if just a few things had been different. This was a lottery ticket. Not a pre-ordained and predictable outcome.
Investing is a probabilistic enterprise. The more factors that need to go right for a company and the lower probability of each of those factors going right contribute to the chances of a particular outcome.
For instance, say that 10 factors contributed to Google’s rise. In reality there are likely thousands but taking a simplistic approach gets the point across. If there was a 25% chance that each of those 10 factors went right and led to Google commanding a dominate position the chances of that happening were less than 1 in a million. To be exact, a 0.00009536743% chance.
If only some of those factors went Google’s way perhaps it would have been a somewhat successful company battling it out with Bing and Yahoo for advertising dollars. “Google” would not have entered the lexicon and there would be no entry for “Google” in the dictionary.
Investors must decide their own approach
As investors we need to decide what types of companies we want in our portfolio. Do we want a bunch of lottery tickets? The chance to strike it rich if one turns into a spectacular success?
We need to consider how this works in the context of a reasonable portfolio. A $1000 investment in Google would have turned into $58,180. What if we invested $1000 in 20 higher business risk companies back in 2004?
One is Google, 10 were companies that earned the average S&P return and 9 went out of business. This is not an unreasonable scenario since most companies that go through an initial public offering don’t make it. In fact, according to work by Ashley Owens published on Firstlinks 99% of the 37,000 companies that ever listed on the ASX became worthless.
Over that same time period since Google’s IPO the S&P 500 went up 353% turning each $1000 investment into $4,530. A portfolio with 20 companies and the outcomes listed above would have returned 8.5% a year. Not too bad. The total price return of the S&P 500 over that period was 7.83% a year. If dividends were reinvested the return would have been 9.92% a year.
Take this how you may. Many of these high business risk companies – including Google – wouldn’t have paid dividends. Yet even without dividends it took finding one of the best short-term business outcomes in history and the resulting high returns to top what would have been achieved from an index fund. Can you consistently find that needle in the haystack and hold it for 20 years?
I don’t personally think I can. What I do think I can do is build a portfolio of companies that pay steady and growing dividends that have low business risk and buy them at reasonable prices. I am no Gordon Gekko. But I’m not trying to be. I’m trying to be Sylvia Bloom. If you haven’t heard of her that is unsurprising. She was an unassuming secretary at a New York law firm who simply bought and held the same shares as her bosses over a 67-year career.
Everyday she rode the subway to and from work and her small rent-controlled apartment in Brooklyn. The type of person who never shocked anyone during her life. She traveled a fair amount and wore custom made clothing. Besides that she appeared to live an average life.
She shocked everyone when she died in 2016. Unbeknownst to her family and friends she had accumulated a $9m fortune. She put it to good use by donating it to provide scholarships for underprivileged kids.
Call me boring or conservative. Pick whatever label you want but I like low business risk companies and ETFs that hold them. Consistency and not losing money on speculative investments is the pathway I’ve laid out for achieving my goals.
The expectations game
This is not to say that every investor will or should make the same decision as I have. However, it is important that investors are thoughtful about how to approach a company with higher business risk. A successful investment involves a company exceeding future expectations. Those expectations can be high or they can be low. It is the relative performance against those expectations that matter.
Expectations are reflected in the price of a company. A higher valuation is a biproduct of higher expectations. A lower valuation stems from low expectations. This gets back to one of the oldest adages in investing. The margin of safety.
My back of the envelope and theoretical look at Google and the factors that had to go right for a research project to grow into one of the largest corporations in the world illustrates this point. A wide range of potential outcomes means that an investor needs to make sure they are getting compensated for taking on a high degree of business risk.
One of the first investors in Google was Jeff Bezos of Amazon fame. He invested $250,000 in 1998. That investment would be worth $4.8 billion today. It could have just as easily all been lost. Regardless of the outcome it appears as though Jeff Bezos took an adequate margin of safety.
At Morningstar the business risk of a company is reflected in our Uncertainty Rating. That rating directly translates into the margin of safety needed to make a share undervalued. A higher Uncertainty Rating – higher business risk – means a larger discount to our fair value is needed for a share to fall into our 4 or 5-star undervalued territory.
This may seem like an overly academic approach to investing. Yet it is common sense. If an investor is going to fill a portfolio with companies that have degrees of business risk and wide-ranging potential outcomes it is important that the winners are big winners.
To become a big winner a company needs to be purchased with a large gap between potential outcomes and expectations – a margin of safety. And an investor needs big winners to make up for the inevitable big losses when things don’t work out for other holdings. The margin of safety will protect investors by minimizing those loses. It goes without saying that diversification is important.
The worst thing an investor can do is purchase a company with a high degree of business risk and no margin of safety. In other words, a company that has priced in an optimistic scenario that has a low probability of occurring. Investors do this repeatedly. Historical examples include the south sea bubble, the tulip mania, the nifty fifty and the .com bubble. More recently we’ve had BNPL and lithium.
As investors we should consider how much business risk we want to take on in our portfolio. As my personal view demonstrates the degree of business risk is not only directly related to the discount to fair value we should demand but also has a knock-on effect on the ability of a company to grow and maintain a dividend and the volatility of the investment. Ignore business risk at your peril.
What kind of companies do you invest in? Let me know at firstname.lastname@example.org