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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

Mark LaMonica: All right, Shani, our topic today is risk. And we do talk about risk a lot on the podcast, but we're going to put a different spin on it today.

Jayamanne: And when we talk about risk, we often hear about volatility or how much the price bounces around in an individual security or in an overall portfolio.

LaMonica: Yeah, and we also talk about the risk of not achieving your goal. But as I said, today's different. We're going to do something that is at the core of investing and one of the most important things that every investor needs to remember. When you buy a share or a fund or an ETF, what you are buying are companies.

Jayamanne: And the more you think about the underlying company or companies that you buy, the better investor you will be. We hear about all sorts of things when we read media accounts of the share market. But almost all of it is about prices. And maybe that is what gets the clicks on articles. But over the long term, what matters is how the company performs.

LaMonica: And focusing on prices, of course, leads to bad outcomes because it heightens the emotions inherent in investing. And that's when we make bad decisions.

Jayamanne: An ownership mindset provides a ballast to share 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 may own may be a better approach for long term investors.

LaMonica: And so today, we're going to frame risk in that way. We're going to talk about the risk of the overall business. And this matters because not only do we care about the risk of future outcomes, we also want to make sure that the businesses that we own align to the outcomes we want from our portfolio.

Jayamanne: So let's start with some fundamentals. 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.

LaMonica: So 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. And the factors that influence future cash flows vary by business.

Jayamanne: 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.

LaMonica: And this gets to my favorite thing to complain about. And of course, that's debt. So debt gets sold as an enabler of choice. But 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.

Jayamanne: So the point of all of this in Mark's rant is that the future pathway for some companies are more predictable. For those companies, maintaining a moderate level of management competence is all that's 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.

LaMonica: And that's appropriate. We mentioned Warren Buffett because we have office drinks.

Jayamanne: In 56 minutes.

LaMonica: Not that you're counting down. Shani goes and grabs like eight beers and hides in the corner, so she doesn't have to talk to anyone. All right. But let's get back to, let's get back to risk and the factors that can influence those future cash flows. So a company with a wide range of factors that influences how they perform in the future has a wider range of potential outcomes, especially if many of those factors are outside of the company's control. The future cash flows that are generated are less predictable.

Jayamanne: If everything goes right, buying shares in that company could be enormously profitable. If even a couple of things go wrong, that same company could go out of business and an investor could lose their entire investment.

LaMonica: Okay. So we're going to use an example, Shani, try to bring this to life. Get out of this theory. Talk about something real. So in retrospect, of course, outcomes appear to be inevitable, but in reality, they're anything but predictable. So going back to 1996, Shani, there are two PhD students at Stanford University named Larry Page and Sergey Brin, and they had to do a research project and they decided to do it on creating a better internet search engine.

Jayamanne: Do you know what else happened in 1996?

LaMonica: Sri Lanka won the Cricket World Cup.

Jayamanne: Yes.

LaMonica: Yes. I'm surprised given the excitement of that event that Larry and Sergey…

Jayamanne: …were able to do this report.

LaMonica: Yeah, exactly. To knuckle down and do this report. So at the time, if we think back to 1996, for those of us who were not three years old like Shani, the market for internet search was really, really fragmented. So a company named AltaVista controlled about a quarter of internet searches. Then a company named Excite followed with a 15% market share, Lycos at 12% and Yahoo at 8%. And after they did this research project, they thought, hey, like we did a pretty good job. That's a good idea. And they founded a company called Google in 1998. And at the time, the internet market, search market, it changed a little bit. Now AltaVista, Lycos and Yahoo handled 50% of total searches.

Jayamanne: 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 one ranking by pulling just ahead of Yahoo, MSN and AOL.

LaMonica: And then in 2007, this is good history of the internet search, which I actually found on the internet. In 2007, Google hit 50% market share. And from there, they kept consolidating their position. And right now, 83% of internet searches are on Google, which is pretty shocking considering they're not allowed to operate in China. And there's a lot of people in that country.

Jayamanne: So this incredible journey was far from preordained. There were thousands of factors that led to the 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.

LaMonica: There are also shifts in the way that governments approach antitrust provisions. And that 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 this growth. The decision by the two founders to put their egos aside and hire an experienced CEO in 2001, created a situation where the investor community trusted them more and led them on to a pathway to becoming public in 2004.

Jayamanne: 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 behavior of billions of people around the world.

LaMonica: And the question is, was creating a better search engine a key factor of this growth? And of course it was. 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 dominant position. Better products that were sabotaged by poor decision making and bad luck.

Jayamanne: And $1,000 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. And this was a lottery ticket, not a preordained and predictable outcome.

LaMonica: And 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.

Jayamanne: For instance, say that 10 factors contributed to Google's rise. In reality, there are likely thousands, but taking a simplistic approach gets that point across. So if there was a 25% chance that each of these 10 factors went right and led to Google commanding a dominant position, the chances of that happening were less than one in a million. To be exact, a 0.00009536743% chance.

LaMonica: That's very exact. You sure you didn't miss a zero because people will send me emails about it.

Jayamanne: I think so. I think we're good.

LaMonica: That's good. So if any or some of those factors went Google's way, perhaps it would have been a somewhat successful company battling 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.

Jayamanne: And this is all about choice. Each investor must decide their own approach. 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 from one turns into a spectacular success.

LaMonica: We need to consider how this works in the context of a reasonable portfolio. A $1,000 investment in Google would have turned into over $58,000. But what if we invested $1,000 in 20 higher business risk companies back in 2004?

Jayamanne: One is Google, 10 companies that earned the average S&P return and nine 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 the work by Ashley Owen published on Firstlinks, 99% of the 37,000 companies that ever listed on the ASX became worthless.

LaMonica: And if we look at that time period since Google's IPO, the S&P 500 went up 353%, turning each $1,000 investment into $4,530. So a portfolio with 20 companies with the outcomes that Shani went through above would have returned 8.5% a year. And that's not too bad. So the total price return of the S&P 500 over that period was 7.83% a year. If dividends are reinvested, the return would have been 9.92% a year.

Jayamanne: And everyone should think about this. 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 a haystack and hold it for 20 years?

LaMonica: Yeah, and I think if I look at myself, I don't think I can. But each investor needs to make their own choice. From my perspective, I think that what I can do is build a portfolio of companies that pay steady and growing dividends and that have low business risk and try to buy them at reasonable prices. And really, at the end of the day, I'm not trying to be Gordon Gekko here. I'm trying to be Sylvia Bloom, Shani.

Jayamanne: And 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.

LaMonica: And every day she rode the subway to and from work in her small rent controlled apartment in Brooklyn. And she seems like, from what I've read, the type of person who never shocked anyone during her life. She traveled a fair amount. She did wear custom made clothing. But besides that, everything seemed just about average.

Jayamanne: And she shocked everyone when she died in 2016. Not her death. Something else shocked people.

LaMonica: Yes, she was very old. When people in their late 90s die, I don't think people are generally shocked. They're shocked every day that they're still alive.

Jayamanne: But her family and friends had no idea that she had accumulated a $9 million fortune and she put it to good use by donating it to provide scholarships for underprivileged kids.

LaMonica: And you can call me boring or conservative, pick whatever label you want. But I just happen to 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.

Jayamanne: And that is what every investor needs to consider. What is the best way to achieve your goals? Every investor shouldn't make the same decision as Mark. 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.

LaMonica: And expectations are reflected in the price of a company. A higher valuation is a byproduct of higher expectations. A lower valuation stems from low expectations. And this gets back to one of the oldest adages in investing, the margin of safety, Shani.

Jayamanne: I'll back up 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 its point. A wide range of potential outcomes means that an investor needs to make sure that they're getting compensated for taking on a high degree of business risk.

LaMonica: And one of the first investors in Google before they went public was Jeff Bezos of Amazon fame. So he invested $250,000 in 1998. That investment would be worth $4.8 billion today. So I think Jeff Bezos was obviously aware of this. It could have just as easily all been lost. Regardless of the outcome, it appears as though he took an adequate margin of safety.

Jayamanne: 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 four or five star undervalued territory.

LaMonica: Okay, so I think it's safe to say that that sounds like an overly academic approach to investing. But in actuality, it's really just common sense. If an investor is going to fill a portfolio with companies that have degrees of business risk, high degrees of business risk and wide ranging potential outcomes, it's important that the winners are big winners.

Jayamanne: And 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 losses. It goes without saying that diversification is important.

LaMonica: And 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. And historical examples include the South Sea Bubble, the Tulip Mania, the Nifty 50 and the dotcom bubble. And more recently, we've had buy now, pay later and lithium.

Jayamanne: As investors, we should consider how much business risk we want to take on in our portfolio. 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. And I think it's fair to say ignore business risk at your peril.

LaMonica: Exactly. So think about some of the investments in your portfolio. Think about the factors that will influence how they do and try to come up with the business risk that you are currently holding and see if that matches the way you want to invest and what your goals are. So thank you very much for listening. We do really appreciate it. And we will be back next week with another episode. But in the meantime, send me an email. My email is in the show notes. Let me know future episode requests or just ask any questions that you may have. Thank you very much.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)