Coffee cup risk
I always enjoy conversations with our deputy Chief Investment Officer, Christian Deckart. Many of Christian’s mental models—or the lens through which he considers investment ideas and implications—are shaped by his background in law. Perhaps most interesting, though, is when Christian turns a legal approach to a problem on its head.
Risk management, for example, came up in a recent conversation we had—namely, the various ways to account for investment risk. To illustrate, Christian swivelled his coffee cup around on the desk, tapping that ubiquitous label: “Caution: Contents may be hot.” It’s a legal disclaimer, he said. It’s meant to act as a hedge against all potential outcomes. But whether the drink is hot or not doesn’t matter. The warning is there—mostly—so that no one can sue and claim: “but you didn’t mention that possibility.” This is similar to a security or fund prospectus listing all of the potential risks and negative outcomes—however unlikely.
As investors, it’s true that we need to assess a multitude of risks when considering an individual investment or an overall portfolio. However, the “coffee cup” approach to risk management fails to account for the probability or severity of a possible outcome—it just provides a list. The investor’s job is to not only come up with a list of possible negative scenarios, but to probabilistically consider the likelihood of these outcomes happening, their potential impacts, any portfolio considerations, and to then make an assessment as to whether the investment can earn above-average, risk-adjusted returns. In other words, it is much more valuable to have a probabilistic risk evaluation process.
As deputy CIO, one of Christian’s responsibilities is to participate in the CIO’s semi-annual risk management assessment: a comprehensive review of our team, process, and portfolios. One component of this report is an evaluation of thematic and systemic risks. It starts with a list of “coffee cup” risks identified by all of our portfolio managers, but each scenario is then scored on a scale of 1-10 along two dimensions: what is the probability of the scenario playing out (“unlikely” to “almost certain”) and how severe might the consequences be for investors (“insignificant” to “catastrophic”). From there, each risk is then plotted on a two-dimensional heat map, which helps us to focus our attention on the most significant mitigation strategies within and across portfolios.
For example, the non-zero possibility of a super volcano erupting in a major financial centre scores highly on the impact axis, but low in terms of probability. However, increasing complacency around corporate leverage to create the appearance of growth scores highly on both axes, and we have deliberately sought to ensure that all of our portfolio managers are cognizant of the degree of leverage inherent in individual positions, as well as for their portfolios overall.
Furthermore, a comprehensive risk evaluation process does more than help protect investors from the downside. Another perhaps overlooked benefit is that it may mitigate a tendency for investors to be myopic to potential upsides.
An example that comes to mind is James Fisher and Sons, a UK-based provider of marine engineering services and one of our global small cap holdings. Before we first bought shares in the company back in 2015, the stock had lost roughly a third of its value as investors seemed concerned about its exposure to capex in the oil and gas industry during a time when the market was spooked by falling oil prices.
But the company’s underlying exposure to oil and gas, in our estimate, wasn’t nearly as acute as the market seemed to be discounting. Their business is actually quite diversified, and our investment thesis was based on James Fisher’s position as a global leader in a host of specialized and critical niche marine technical services: mooring and fendering, the facilitation of safe and efficient ship-to-ship transfers—even submarine rescue operations.
Looking back today with the benefit of hindsight, the portion of James Fisher’s business most exposed to oil and gas has suffered, with profits in their offshore services segment down 80% over the past four years. But that didn’t mean that the stock was as risky as it was characterized in 2015. Certainly that it had some exposure to the oil and gas sector had to be factored into our valuation work. But the due diligence and, we would argue, edge, lay in reasonably and probabilistically accounting for the magnitude of that risk.