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O Risk Manager, Where Art Thou?
Investing without risk control is like playing high stakes poker without the ability to lay down Aces or Kings. You’ll do ok for a while, maybe even a good while, as rockets and cowboys are always great starting hands. But sooner or later, not folding will get you felted. Or, to put it another way:
If you want to avoid being a “Manager of Constant Sorrow” (ok sorry that was bad), keep a handle on your risk at all times! Not like the guys in this write-up (emphasis mine):
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Get our best content delivered FREE to your inbox! Check out the Mercenary Dispatch page to learn more. It never fails to amuse. After all this time, how is it that professional traders are collectively written off as wild gunslingers, while the reckless risk takers of the mutual fund industry get a “prudent” and “respectable” stamp? I mean come on… 74% of assets in financial stocks? Is that anything but a massive speculation, given the utter lack of downside protection? Berkowitz obviously has high convictions, i.e. a very strong opinion, that he is right. Fine. Except, as responsible traders, we always make contingency plans for being wrong. Does he? When price action doesn’t matter and “wrong” is stricken from your vocabulary, being down just becomes an excuse to buy more. Bill Miller articulated this way of doing things some years ago, when someone asked him at what point he stops buying a declining name he likes. His answer: “When there is no longer a price quote.” Some risk control eh? Now let’s take a quick look at XLF (the financials ETF):
Doh! We’ve been short XLF from May 4th (red arrow) as timestamped in the Mercenary Live Feed. But the key point is — if the trade hadn’t worked, we would have gotten out. Risk management was (and continues to be) a critical part of the process at all times. So at what point do Berky and Miller get out of their losing longside bets? If financial stocks drop another 10% lower from here? 20%? 50%? When investor redemptions carry them out?
WHERE’S THE RISK CONTROL? Seven Little Words As Mercenary Traders we eat heaping helpings of our own cooking, and that’s the way we like it. But were I to give another manager a chunk of capital, or select a money manager on behalf of a friend, the interview would start with a very straightforward request: “Tell me about your risk management process.” One little sentence, seven words long, absolutely critical: “Tell me about your risk management process.” If the guy (or gal) came back with some canned answer, or something about only picking the soundest stocks — or, worst of all, some shpiel about adhering to a benchmark — I wouldn’t give them a fifth grader’s lunch money, let alone a meaningful sum. I mean here is the irony of it:
I will ALWAYS give my money to the risk aware trader, given any semblance of choice. He’s the only true risk manager of the bunch! Not even value investing One other bemused point, re, “value investing” in financial stocks. As we stated in a recent presentation at a hedge fund conference, we wholly agree with value investors that “volatility and risk are not the same thing” — and that it is far more logical to view risk as the prospect of permanent capital loss (versus some pre-packaged measure of volatility). With that said, it seems dead obvious to us that the mega-financials are not true “value” stocks. How so, you ask? Well, first consider Warren Buffett, the patron saint of value investing. Buffett has said diversification is di-worse-ification, and makes a very strong case for concentrated bets. So far, so good. And over the course of his career, Buffett was famous for taking huge positions (relative to total assets) in companies like American Express, Geico, the Washington Post, and Coca-Cola, sometimes plowing 25% of his assets (or more) into a single stock. Still “so far so, good.”
In other words: Buffett could properly assess the risk levels and intrinsic value of these businesses because he could understand them. The money center banks, on the other hand, are the most opaque (i.e. non-transparent), complex, impossible-to-value businesses on the planet! Think that’s exaggeration? Paul Singer of Elliott Management runs one of the most successful distressed debt funds on Wall Street ($17 billion under management, in business since 1977). This guy is the king of extracting value from debt deals with hair on them. And yet, Singer has said his ace team of analysts can’t even understand, yet alone properly assess, the macro-contingent balance sheet risks of the big megabanks. Via WSJ interview:
How do you find value in something you can’t even get your head around? Bill Miller of all people should know this. Why? Because Miller blew up buying financial stocks in 2008 — or rather, buying more and more on the way down (until his investors and reputation were toast). There is a difference between a value proposition — buying something you can assess and understand — and buying a black box where the true risk isn’t even comprehensible. During the heat of the financial crisis, many investors thought they were scooping up deep value (in the form of beaten down financial stocks) — but were actually purchasing booby-trapped black boxes (that proceeded to blow up in their faces). And now they are doing the same thing again! We still don’t know what kind of embedded risks the banks hold… how double-dip fallout might effect them… or even whether they are all truly solvent. In the latest bit of hilarity, via Kash Mansori / John Mauldin, American banks may even be leveraging up on Greece at the worst possible time:
And the best part of it is, we’ve seen this movie before — and not all that long ago! (Remember all those smug folks so sure Bear wouldn’t go under… and then Lehman?) Do these guys have the memory of a goldfish or what? In a write-up far more charitable than ours, our friend Josh Brown says “The three managers mentioned here are brilliant and will go into the stockpicking hall of fame.” Well hey man, I don’t know about you, but if that counts as brilliance I’m not sure I want any. If someone has to run my money other than me, I want to make damn sure he isn’t so “brilliant” as to ride his convictions (and MY capital) straight into the @#$#@ ground! And again, a word of humble advice. If you are ever in a position to allocate money — especially your own or the funds of someone you care about — just remember this request: “Tell me about your risk management process.” If the answer sounds like evasion or consultant-speak or gobbledygook, or worse yet if they don’t have an answer at all — run! JS p.s. Like this article? For more, visit our Knowledge Center!p.p.s. If you haven't already, check out the Mercenary Live Feed!  Similar articles you might like: |
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Damn! We’re in a tight spot!
It’s like the little old lady in those classic “Where’s the Beef” commercials. 
But here’s the rub: All of Buffett’s “back up the truck” picks were relatively simple, transparent businesses, with a small handful of moving parts.