Value investing teaches that when you see a dollar trading for fifty cents in the market, you should buy it. Theoretically, this will always be true. But in practice, are there times when the investor should not be so hasty? It is the marriage of risk management with investing that produces potential instances when undervalued stocks should not be acquired. As strange as this sounds – and is never easy to practice – it is the view of your author’s that risk management should always come first. Here is a simple (and completely stylized) example that illustrates such an instance. Imagine you own the following basic $1 million portfolio:

• 8,000 shares in Company X with a stock price of $100/share; giving total equity value of $800,000.
• $200,000 in cash (earning zero interest, to keep the numbers simple).

Now let’s assume you believe Company X has an intrinsic value of $140/share. If the market drove the stock price to its intrinsic value tomorrow, the portfolio would be worth $1.32 million, or +32%. But instead, the stock price of Company X starts to fall. Now, typically a disciplined active manager should add to the position on the way down. Let’s call this Scenario 1:

• Manager adds to the Company X position +3% of the portfolio for every $5/share decline.

Now, as the manager is following his or her standard process, surprise ensues when the stock keeps falling. And falling, and falling further again. The stock is now at $40/share – much lower than the manager ever anticipated could be possible. Still, the manager has continued to add to the Company X position which now represents 94% of the portfolio. What is the status of the portfolio at this point?

• The manager has invested an aggregate of $972,000 in Company X; which now carries a market value of $423,000.
• The aggregate portfolio is worth $451,000, down (55%) from its starting point.

Still, the manager – with nerves of steel – sticks to his or her convictions and the stock finally reverts to its intrinsic value of $140/share. At this point:

• The portfolio is worth $1.51 million; up +51% from its original starting point.

As you can see, in Scenario 1, the manager has used discipline to buy on weakness to ultimately enhance portfolio returns. It was a scary ride for investors being down (55%) in the interim, but for those who resisted the urge to redeem at the bottom, the reward was handsome at +51% return when all was said and done. Let’s now imagine Scenario 2in which the manager envisages the possibility that the stock could fall significantly for, say, non-fundamental reasons or some exogenous shock unrelated to the business of Company X itself. The manager then employs the following risk management actions:

• Reduce position in Company X by 20%; thereby boosting cash holdings while the stock falls.
• Wait until the stock price of Company X hits $40/share – at which point increase the position to result in a 94% portfolio holding in Company X (to keep the endpoint the same as Scenario 1)[1].

Now, under this scenario, when the stock hits $40/share:

• The portfolio is worth $631,000, down (37%) from its starting point.

And when the stock finally reverts to its intrinsic value of $140/share:

• The portfolio is worth $2.1 million, up +111%.

Source: MGI

Immediately, the stark difference between Scenarios 1 and 2 can be observed:

• Scenario 1: the value of the portfolio declined by (55%) before finishing up +51%.
• Scenario 2: the value of the portfolio declined by (37%) before finishing up +111%.

The judgement by the manager that the decline in Company X’s stock price was going to be unusually deep and/or persistent allowed for a course of action that reduced risk up front, thereby avoiding much of the downside, and increasing the dry powder that could be deployed later when the stock price was significantly cheaper. Now, hold on just one minute, I hear you say: what if the manager employed the course of action in Scenario 2 but missed the bounce in the stock price back to $140/share. That is, the manager was caught out holding too much cash when the stock finally re-rated back to $140/share. In this instance:

• The value of the portfolio ended up at $1.23 million, or up +23%. This is obviously less than the original 32% expected return, but not by much.

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Here is the challenge with investing. One cannot be so formulaic that buying and selling is simply a function of the stock price. While a systematic framework that maps portfolio position sizes to risk/reward/conviction parameters is enormously helpful, one’s process still needs flexibility to deal with unanticipated market events. Risk management, in our view, is about ensuring one’s portfolio will be ok in all possible scenarios – not just the probable scenario. It’s about ensuring capital is not permanently impaired – even if that means forgoing some of the upside. Deploying more capital into stocks when they are undervalued is the right thing to do, most of the time. But as this example seeks to illustrate, there can be unusual, unanticipated scenarios when reducing risk is the more prudent course of action to take – even if that means selling undervalued stocks in the near-term. Over the longer term, we believe prioritising risk management will result in higher returns, with lower risk, for our investors. APPENDIX – Detailed Calculations [1]The obvious and valid question here is: how did the manager know $40/share was the bottom? For the purposes of this simplified example, the question is noted but will remain unanswered. Andrew Macken is Chief Investment Officer with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.