Risk Management

Assessments

We attempt to identify and discuss specific possible fundamental events which could materially impact a company’s business and which would therefore cause a substantial rise or decline in the company’s share price.  We perform these “assessments” on a regular basis for all our holdings in order to determine the risk of a substantial and perhaps permanent loss of value of each position. We look at a substantial and permanent loss of value as the true risk in each position rather than a quotational aberration, as substantial declines are often the result of significant fundamental events.  This process is iterative: through continued due diligence including conversations or meetings with companies, suppliers, and competitors, we reconsider the risks that each company’s business is likely to encounter.

We call extreme negative events “P10 events” as we consider them to have a 10% chance of occurring over the next year while we call extreme positive events “P90 events” as they are in the 90th percentile (top 10%) of possible positive outcomes over the next year.  We consider a wide range of outcomes and discuss the likely impact to the company’s fundamentals and subsequently on its stock price.  We believe that thinking about outcomes and valuation from a probabilistic perspective – specifically considering best and worst case scenarios – as opposed to merely single point estimate of future results is more robust and reduces the risk of our portfolio.

Once we have identified these P10 and P90 events for each holding, we estimate where share prices would go should one or more of these P10 or P90 events come to pass. We then compare the current share price of each holding to these P10 and P90 prices to determine the absolute and relative upside and downside potential of each of our holdings under various extreme fundamental scenarios.

We consider the “risk” for each holding that extreme events drive the share price much higher or lower when establishing and reviewing our position sizes. The process of identifying and reviewing these assessments helps us to think about significant events which could happen and the risk/opportunity to our positions should they come to pass.

This is not strictly an academic exercise, as one would expect that of approximately twenty holdings, two might experience P10 and two might experience P90 events in any given year.

We believe it is imperative to have considered these scenarios before they happen and be prepared to act decisively rather than be surprised by unanticipated events and spend perhaps crucial time determining the impact on the company.

IN OUR VIEW, THERE ARE TWO SEGMENTS OF RISK: One is the risk that a company flounders and goes into long decline like many companies in the domestic steel industry in the last half of the 20th century, or in the case of newspapers since the late 1990’s. Such erosion of a company’s position may emanate from internal sources such as bad management, or externally from a change in the competitive balance within the industry, or from increased foreign competition. The other type of risk, market risk, is the risk of the individual stock or the general market declining and eroding the price of stocks.

Our stock selection process is our first weapon against both kinds of risk.

We contrast a company which gets into long term trouble with a company that continues to grow from decade to decade. For example, we would contrast Bethlehem Steel with Coca Cola, or The New York Times with Wal-Mart.  In our conservative approach to investing, we do not think we need to reach into speculative realms to garner superior results. By staying away from debt-ridden secondary or tertiary companies that no longer dominate or lead their respective industries, we believe we are limiting company risk. Stock prices and company earnings are correlated over long periods of time; thus a company with a strong competitive position and growing sales and earnings is, in our opinion, the best prevention against the long-term erosion of principle and the most effective method to build capital.

Our pricing disciplines can turn an investment in an outstanding company into a bargain purchase, but they do double-duty by reducing downside quotational risk.

We limit market risk if we do not overpay. We avoid

overpayment by the pricing mechanisms and disciplines described in the Investment Process section. The risk of a general market decline can be damped by observing our pricing disciplines across the entire portfolio.

Balanced and Fixed Income Account Risk Management

In balanced and fixed income accounts, we are experienced at constructing diversified and defensive portfolios of high grade bonds that, even more than in our equity portfolios, put preservation of capital ahead of high returns. In bonds, since the investment pays off at par, there is little or no appreciation potential (unless the bonds are bought at deep discount) so it makes no sense to sacrifice safety for high yield.