It is well known that Warren Buffett has beaten the broad market indices over a very long period of time. It is also known that he has done so while taking lower risk. But what exactly is his approach to risk? We shall try to answer the question in this article.
Warren Buffett's method
Let us pick two cases from different points in Buffett's illustrious career. Case 1 is his investment in American Express around 1964. At that time, a subsidiary of American Express had certified how much salad oil was stored in its warehouses by a commodities trader. The trader turned out to be a fraud, who used these certificates as collateral to borrow from banks. When the fraud was uncovered, American Express stock tanked. Case 2 is his investments in South Korean stocks in 2004. He had received a book full of information on South Korean stocks. He pared the list of thousands of stocks to a small number. The final list contained several small companies.
An analysis of Buffett's method of dealing with risks in these two cases reveals a pattern. Following are the steps that he uses in dealing with risk.
Step 1: Realise that there is always some risk. If a stock has been battered down, it is because the market perceives some risk.
Buffett's mentor, Ben Graham was extremely risk averse due to his experiences during the great depression. Graham focused on liquidation values, completely ignored qualitative judgments and pursued extreme diversification to avoid any risk what so ever.
However, Buffett learnt that avoiding all risk at all cost will hurt his performance. As Warren Buffett says in book 'The Snowball', "The future is always uncertain...When you invest, you have to take some risk."
Step 2: Analyse exactly what specific risk the market ascribes to the stock.
In the case of American Express, the market was not sure if the company would survive. The market also seemed to feel that the scandal had maligned the company's reputation to such an extent that customers no long trusted the brand. Buffett also found out that the company was not formed as a limited liability corporation. Hence large institutional shareholders panicked, thinking they might be held liable to make good the losses caused by the fraud.
In the case of South Korean Stocks, Warren Buffett felt that the main risk of why they were cheap was North Korea, which was a real threat. In fact, Buffett himself regarded it as one of the world's most dangerous countries.
Step 3: Ensure you are within your circle of competence, i.e. you have the capacity to assess the risk.
American Express's main business was credit cards and Travelers Cheques. Buffett understood the business. The South Korean companies made basic products like steel, cement, flour and electricity, again something he could understand
Step 4: Handicap the risk or assess the odds of the bet.
In the case of American Express, Buffett visited restaurants in Omaha that took the company's cards and Travelers Cheques. He also read the research compiled by a friend. He concluded that the average American customer was still happy to associate himself with the brand. The business was likely to survive.
In the case of South Korean Stocks, he says in 'The Snowball', "I would make the bet that the rest of the world, including China and Japan, are simply not going to let the situation get to the point that North Korea makes a nuclear attack on South Korea anytime soon".
Step 5: Build a margin of safety in quality and buy price.
Buffett felt American Express had a strong brand. He also bought the stock at an attractive price, which had fallen 50% due to the scandal.
He ensured that the South Korean companies he picked up made basic commodities. Customers would still be buying the product in ten years. These companies had a big market share in Korea, which wasn't going to change. In addition, some of these companies were exporting to China and Japan. Buffett also ensured that he bought at attractive prices- companies with market capitalisation less than the cash they held, with a price to earnings multiple of 3 times, etc.
Step 6: Concentrate or diversify depending on the degree of familiarity.
He concentrated in the case of American Express because of his familiarity with the company. However, he diversified in the case of South Korean stocks due to his unfamiliarity with the management and South Korean accounting practices.
Using the method to take a call on oil prices
Buffett's method of dealing with risk can be applied to a variety of situations. Let us use his method to take a call on crude prices.
Steps 1 & 2: Realise and analyse the risk. What is the risk associated with crude price? Answer: Low demand from developed countries and stagnant demand from emerging countries like China and India.
Step 3: Circle of competence. Do you understand oil? That's for you to decide, dear reader. We believe that tracking the sector does give a reasonable idea of its developments.
Step 4: Assess the risk. Will the people in developed countries simply give up their energy intensive life styles? Unlikely. Now that the average Chinese and Indian is exposed to the good life (read energy intensive way of life), will he stop aspiring for better lifestyles? Unlikely. So will the demand for oil be perpetually depressed in the future? Unlikely. Hence, oil prices are unlikely to be perpetually depressed below US$ 40.
Step 5: Margin of safety. With the oil prices below US$ 40 per barrel, there a margin of safety in terms of price. If prices go below US$ 30, the margin of safety increases further. If you seek to bet on oil price through the medium of oil producers like ONGC, you have to make sure that your buy price for the stock provides a margin of safety.
Step 6: Diversification. If you understand the oil producing company, you can concentrate. If you feel unfamiliar with the company, you can hold it as part of a diversified portfolio.