ENJOY-UNCERTAINTY_cropInvestment risk and uncertainty are often mentioned in the same breath by investors. We’ve all heard the following or similar statements: “There’s too much uncertainty, so it’s too risky for me to invest right now,” or “I’ll wait until there is more clarity,” or “This situation is too uncertain, I wouldn’t touch the stock with a ten-foot pole.”

Indeed, the uncertainty of business outcomes and their probabilities plays an important role when assessing the investment risk of a particular stock. However, the assessment of investment risk does not end there. As any value investor knows, the price of the stock is another key element to consider. As Howard Marks reminds us in his invaluable book The Most Important Thing, “No asset class or investment has the birthright of a high [or low] return. It’s only attractive if it’s priced right.” In fact, price is the great disentangler of investment risk and uncertainty! At the right price, stocks with even the most uncertain business outcomes can carry low investment risk. On the other hand, at a certain price, situations with a high degree of certainty can lead to high investment risk (think, for example, long-dated U.S. treasuries at yields in the low single digits).

Investment Risk and Uncertainty — A Question of Price

Many investors will proudly say they aim to avoid uncertainty and investment risk. We disagree with this aim.

Uncertainty related to the fundamentals of a business or industry can actually be a fruitful source of mispricings, i.e., investment opportunities that a skilled investor can take advantage of. That’s because the first reaction of many investors who are confronted with uncertainty is to sell. As a result, uncertainty is often accompanied with bargain basement prices. Rather than avoiding uncertainty, we therefore embrace it in our search for investment ideas. What about investment risk? Again, price is one of the key elements to consider. As Howard Marks explains:

Once in a while I hear someone talk about Oaktree’s desire to avoid investment risk and I take great issue. Clearly, Oaktree doesn’t run from risk. We welcome it at the right time, in the right instances, and at the right price. We could easily avoid all risk, and so could you. But we’d be assured of avoiding returns above the risk-free rate as well…So even though the first tenet of Oaktree’s investment philosophy stresses ‘the importance of risk control,’ this has nothing to do with risk avoidance. It’s by bearing risk when we’re well paid to do so-and especially by taking risks toward which others are averse in the extreme-that we strive to add value to our clients.

So, in a way, uncertainty related to a company’s prospects (for example, due to regulatory intervention) represents fundamental risk in the sense that London Business School Professor Elroy Dimson defines risk: “Risk means more things can happen than will happen.” Surely, when regulators take aim at an industry more things can happen than will happen for a particular company in that industry. However, to conclude that this raises investment risk would be erroneous. One needs to look at the company’s share price, which perhaps has declined as some investors have sold their shares in order to avoid the uncertainty associated with the company. This may have resulted in the intrinsic value of the company being higher than its share price, even if the worst case materializes for the company as a result of regulatory intervention into its industry. Of course, there is still investment risk remaining in the sense that every outlay of capital carries certain investment risk with it. However, the key is whether the investor is well-paid to take the investment risk implied at a certain share price.

Uncertainty and Time Horizon

Robert Hagstrom, author of The Warren Buffett Way, discusses the impact of time horizon on uncertainty.

Watch the full conversation in The Manual of Ideas Members Area.

What’s Your Circle of Competence?

Value investors are fond of saying that certain areas of investing are within their circle of competence, while others lie outside. Most often this is applied to certain industries or geographies. Accordingly, some will profess that their competence is within the consumer sector, while financials or technology companies lie outside their circle of competence. Many U.S.-based investors will not venture outside the U.S. when looking for investment opportunities, citing language, corporate governance or other considerations. However, there is a dilemma here that is related to our discussion of uncertainty and investment risk. In an interview with The Manual of Ideas, Howard Marks has eloquently described this dilemma:


Watch the full conversation in The Manual of Ideas Members Area.

It is a great dilemma because, on the one hand you want to stick to your circle of competence. On the other hand, it is probably a mistake to say, ‘I do this. I don’t do that.’ Because, at the same time that you want to capitalize on your expertise, you want to be flexible enough to pursue the bargains where they are, and you don’t want to be so dogmatic that you say, ‘I only do this,’ which implies, I do it whether it’s cheap or not. So this is one of the great dilemmas. You asked earlier where inefficiencies come from. Largely they come from people who say, ‘I do this, and I don’t do that.’ What they are basically saying is, ‘I don’t do that regardless of how cheap it is.’ Well, that is silly because then you just leave bargains for others. If you say, ‘I do this, but I don’t do that regardless of how cheap it is,’ you are basically saying, ‘I do this regardless of how expensive it is.’ That doesn’t make much sense either.

This dilemma leads us to consider that the greatest circle of competence for an investor may not be competence in a particular industry or geography, but competence with regard to inefficiencies, i.e., mispricings: how to identify mispricings, how to select the most favorable mispricings in terms of risk-reward, and how to construct a portfolio of mispriced securities. In this context, recognizing the need for disentangling investment risk and uncertainty is a key ingredient to success along the way.

Uncertainty Equals Opportunity?

Phil Ordway, Principal and Portfolio Manager of Anabatic Fund, explains why he seeks uncertainty and how other investors’ aversion to it enables disciplined investors to profit from it:

Watch the full conversation in The Manual of Ideas Members Area.