High returns need not come with high risks

WHAT is risk? The conventional definition of risk in finance literature is price volatility. But to super-investor Warren Buffett, risk is the permanent loss of capital.

Unless you need to cash out at very depressed market levels, or the investments or stocks/companies you own have no more capacity to recover, price volatility is just noise in the market, says Buffett.

On the other side, what is return?

Return to an investor is the income you get from your investment as well as the rise in the price of the investment. Of course, you’d want to get back the entire sum of the capital you put in at some point as well.

How does one get good return from an asset? Well, the more cheaply you can acquire a good asset, the higher your return will be. Your dividend yield is higher, your capital appreciation is higher.

Next question. When you get a good asset cheap, for example when you pay $0.60 for something that’s worth $1, what are the chances of you suffering a permanent loss of your capital? Small. Hence, your risk is low.

So, to get good returns, does it mean you have to take high risks? No!

Human weakness

It is very common for us to miscalculate the probabilities and act less than rationally because of our tendency to, among other things, prefer excitement over staidness, to want instant gratification instead of staying for the long haul, and to seek “safety” in numbers, that is, to just follow the crowd.

Take Apple. Given how well the stock has done, I’m sure most of us wish we had the stock in our portfolio, preferably from as early as 10 years ago. A sum of US$10,000 invested in April 2004 in that “fruit company” – as Forrest Gump described it – would have grown to about US$400,000 as at end-March 2014.

But nobody could have predicted back then how well Apple would do. This is but one of the many trajectories that the company could have taken in the intervening 10 years. It could have gone the ways of Nokia, Compaq or Gateway.

In expectation, as scholar and investment expert Nassim Taleb puts it, a dentist is considerably richer than the rock star, the hedge fund manager who made it with one big bet or the successful entrepreneur. “One cannot consider a profession without taking into account the average of the people who enter it, not the sample of those who have succeeded in it,” he says.

We talk about Apple today because it has succeeded. And that’s how typically a stock comes onto the radar of a novice retail investor. The stock is in the news because the company has had three or four years of good growth, or has a novel concept. Our friends and family members talk about the stock because it is in the hottest industry today.

But most times, such stocks will prove to be a less-than-satisfactory investment.

A few things are at play here. One, because of their promise, the hype factor and the fact that many people are chasing after them, the prices of these stocks or asset classes are bid up. They become expensive.

Two, because their prices are bid up and the market’s expectations for them are so high, everything must go right for them. Any little disappointment – and they will definitely run into some – will cause the stock prices to fall. The more expensive they are, the more they can fall.

Three, being the darlings of the stock market does something to the management of the companies. Their egos become a bit bigger, they take a few more risks and they become a tad more tyrannical. Thus, the seeds of their downfall are sown.

Boring pays

Numerous studies have shown that, on average, investing in stock-market darlings, buying into high-growth companies, chasing after the latest investment fads, does not pay. Instead, it’s the boring stocks, the neglected stocks, the shunned stocks, that give investors the greatest upside.

Contrast companies that promise world domination with the unexciting ones that cough up consistent cash flows without the need for massive capital expenditure on a regular basis. Without a doubt, the latter group trumps the former.

Here’s the proof. In the past 10 years, the ten best performing stocks on the Bursa included the likes of milk powder and fruit juice producer Dutch Lady; mobile service provider DiGi.com, biscuit and coffee mix maker Hup Seng Industries and manufacturer of materials for packaging and automotive interiors cum property developer Scientex Bhd. Nothing too exciting about these businesses.

An investment of RM10,000 in Dutch Lady 10 years ago would have grown to about RM234,000 as at end of March, with dividends reinvested in the stock. Not too shabby.

There you have it – you can have your cake and eat it. You can get good returns, without taking on a lot of risk.

Just a word of caution. Remember, the stocks mentioned above came to our attention because they have done very well. And because they have done so well in the past 10 years, a certain amount of premium has been factored into their share prices. They might not be that cheap anymore relative to their business fundamentals. Hence, they might not be as “low-risk” as before. A case by case analysis needs to be done on each one of them should one still be keen to invest in them.

And because of their bigger size today, it is also highly unlikely that they will chalk up a return as spectacular as that of the last ten years in the next 10.

And so, the search continues for the next batch of safe and good stocks.

Just to recap, risk in investing is permanent loss of capital. That happens when you overpay for an asset, for example paying RM10 for something that’s worth only RM2. When the price falls to fair value, it’ll be very hard for you to recover that RM8. High return is obtained when you underpay for an asset, i.e. paying RM6 for something that’s worth RM10. In the next few articles, we’ll look at some metrics used to measure the value of an asset/a business/a stock.

• The author was a multi-award winning investment columnist in Singapore who is now a partner in Aggregate Asset Management, manager of a no-management fee Asia value fund.

• The views expressed are entirely the writer's own.