Assessing Permanent Loss Of Capital

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In investing, there are 2 schools of thoughts about risk:

• The volatility school that view risk as variance.

• The permanent loss of capital school that view risk as a permanent reduction of the amount invested.

The volatility school has strong academic credentials. This branch of finance theory has developed to a stage where you can numerically bring risk into the valuation process.

But all the discussions on risk as permanent loss of capital are qualitative.

If you are investing following the permanent loss of capital school, how can you manage risk? Specifically

• How to compare risks between two companies?

• How to methodically bring the permanent loss of capital into the investment process?

This can be achieved through a risk management approach comprising:

• Identifying the possible causes that can lead to a permanent loss of capital.

• Assessing the threats.

• Mitigating permanent loss of capital using risk management strategies. It involves avoiding, accepting, reducing, or transferring them.

This risk management framework enables you to compare the permanent loss of capital for different stocks. It also integrates the permanent loss of capital into the investment process.

Contents

• Risk Management

• Possible causes for permanent loss of capital

• Assessing the threats

• Case study

• Risk mitigation

• Pulling it together

Source: Author

Risk management

The risk management process involves the following:

• Identify the causes that can lead to the risk.

• Assess the risk in the context of the impact and the likelihood of the occurrence.

• Formulate the mitigation measure to manage the risk.

The strategies to manage them cover:

• Avoidance - what can be done to prevent it from happening.

• Reduction - how to minimize the impact of any risks.

• Transfer - is there a way to transfer the risk and/or the consequences to another party.

• Accept - in some instances where the cost of mitigation outweighs the benefit of the mitigation strategies, it may be better to live with the risk.

If you consider the permanent loss of capital as risk, there is no reason why we cannot use the risk management framework to manage risk.

Possible causes for permanent loss of capital

To suffer a permanent loss of capital, the investment has to be sold at a price that is lower than the buying price.

For simplicity, I will ignore the situation where the investment has been sold due to short-term volatility. From a value investment perspective, this is unlikely to happen.

Rather I assumed that any sale is because the price is “permanently” below the purchased price due to the following direct reasons:

• Deterioration in the intrinsic value due to changes in the fundamentals - both macro and micro.

• Issues with portfolio construction.

• Wrong assessment of intrinsic value in the first place.

• Stock market changes due to regulatory changes.

These are the main direct causes and there are other root causes for each of them.

To help identify the root causes, I have used the Ishikawa fishbone diagram to help identify the various cause-and-effect.

Source: Author

The details of each of the root causes for the boxed items in the Ishikawa diagram are presented below

Stock Market Changes

• Privatization - you are sometimes forced to sell at below your purchased price due to a privatization exercise.

• Regulatory - these relate to rules that affect the availability of the stock e.g., trading restrictions. There is a “feedback loop” here. If the business deteriorates, there is a higher likelihood of some listing guidelines that may affect its liquidity.

Wrong initial intrinsic value

The assessment of intrinsic value is the heart of value investing. If this was wrongly assessed at the start, the purchase would be a mistake that would be realized much later.

• Governance. The intrinsic value is generally assessed based on the financial statements. If there are issues due to the poor quality of earning or even creative accounting, the computed intrinsic value would be wrong.

• You could have made some analytical errors in assessing the intrinsic value. You are more likely to make errors if the company has a more complex business model

• Your behavioural biases can skew your estimates of intrinsic value. Again, there is a high likelihood of more behavioural biases in analyzing and valuing a company with a complex business model.

Portfolio construction

• Position size. This relates to the number of stocks in the portfolio and the amount to be allocated to each stock.

• Cash management. From an individual investor perspective, the amount of cash you hold affects your holding power. You should have enough to handle emergencies without being forced to sell your shares at the wrong time. The amount of cash also affects the ability to take advantage of the market but I don’t see this as critical in the context of a permanent loss of capital.

• Hedging refers to other strategies of guarding against risk e.g., taking a short position

Deterioration of intrinsic value

The intrinsic value of a company could decline over time. Over the long term, the market price will decline to reflect this.

• Management could be the cause of the decline. This could be adopting the wrong strategy or plain incompetence.

• Financials - if the company has debt, there could be changes to the loan situation e.g., higher interest rates that affect its profitability or cash flow.

• External - this covers all the social, political and economic changes that negatively impact the company. I would include technological changes here as well.

The above Ishikawa diagram shows the first level cause-and-effect. You can have a second or even third level cause-and-effect diagram for the more complex cases.

For example, in the case of the External factors, you could further break it down into:

• Different economic factors e.g., interest rate, GDP growth, inflation.

• Different social factors e.g., demographic trends, migration patterns.

Assessing the threats

The goal of threat assessment is to evaluate the likelihood of occurrence of each of the threats and the impact.

I classify each cause in the Ishikawa diagram into one of the following 4 coloured cells based on the assessment of its impact and the likelihood of it occurring as per the table below

Source: Author

Case study - Comparative visual assessment

To be able to assess the threats, there is a need to first analyze the companies. Such analyses have been carried out for 2 Bursa Malaysia listed companies - Eksons and Asia File - which are analyzed elsewhere.

(Note: This approach requires an in-depth knowledge of the companies and as such, I have used Malaysian companies that I am familiar with to illustrate the approach).

For each company, I categorized each of the causes of permanent loss of capital (as per the Ishikawa diagram) into the relevant threat category (as per the Threat matrix).

The comparative results and rationale are tabulated below.

Based on a visual comparison, you would conclude that an investment in Asia File would have less risk compared to a similar investment in Eksons.

The above is mainly a first level cause-and-effect assessment (although I did go down to the second level in the case of the External factors).

You can go down into a second or even third level cause-and-effect assessment if you need to.

Source: Author

Notes

a) Any regulatory issues affect both companies equally.

b) Because of the shareholders' profile and cash available in the company, I consider a greater likelihood of Eksons being privatized. Of course, whether you suffer a permanent loss of capital would depend on your purchased price.

c) Since both stocks are in the same portfolio, they share the same risk profile and, hence I have not attempted a finer breakdown.

d) I use the same analytical process for both so they share the same assessment. My margin of safety minimizes the impact of any error here.

e) I relied on my rating system Q Rating to assess Eksons to be riskier. My margin of safety minimizes the impact of any error. You could employ any governance assessment approach for this.

f) Eksons has a simpler business model and hence less analytical and valuation issues.

g) Both companies are financially strong.

h) Asia File is more likely to face digital disruption.

i) Eksons is facing log supply issues resulting from the government logging policies.

j) Asia File management has a stronger track record.

What to do with the results

Although this is a simple visual assessment, I have used the results in the following manner:

• Position sizing. The concept behind the Kelly Formula is to invest more in those with the greatest payoff and the best probability of success. I translate this to mean that I invest more in Asia File compared to Eksons. I believe that this is in line with the idea that you invest more in those with a higher conviction.
• The margin of safety. This margin is to protect you against bad luck and other errors made in the investment process. I would require a smaller margin of safety for Asia File compared to Eksons.
• In portfolio construction, you have to select among various stocks. You could use this assessment method to select the less risky ones for the portfolio.

But the most important useful thing about this risk management framework is that it provides a comprehensive way to identify the various risk mitigation measures. An example of this is presented in the next section of this article.

Pros and Cons of the methodology

The goal of the assessment is to have a standard way of comparing the risk between several companies.

A visual assessment serves this purpose.

Unfortunately, it is not very meaningful if you want to assess the risk of just one company.

I see the following as the Pros and Cons of this approach:

Pros

• Simple visual assessment.

• A consistent basis to compare.

• Relates to the reasons for permanent loss of capital i.e., risk.

Cons

• Requires detailed analysis of each company.

• May not be practical if comparing many companies together.

• Different parties may come to a different assessment.

• Dependent on identifying the correct cause-and-effect.

Risk mitigation

Given the various items that can lead to a permanent loss of capital, the risk management approach is to identify various measures to handle them.

The table below summarizes the various measures that I have adopted categorized into:

• Avoiding the threats.

• Reducing the likelihood or impact of the threats.

• Accepting the threat.

You will notice that some measures cut across several risk mitigation categories.

At the same time, to transfer some of the risks, I have some of my net worth invested in unit trusts and properties. These have a different risk profile than those of stocks.

Furthermore, if you view the threat as a function of both the likelihood of the event and the impact of the event, then depending on the nature of the threat,

• Some of the measures focus on the likelihood.

• Some focus on the impact.

• Some cover both likelihood and impact.

Most of the measures adopted a self-explanatory. But for some others, I provide a brief description (in alphabetical order) as follows:

• Analyze shareholders - privatization will also depend on whether the controlling shareholder sees any advantages in maintaining the listing status.

• Avoid deep value - deep value stocks are those that are generally trading at a deep discount to the Asset values. These are potential privatizations.

• Cap investment - this is to ensure that there is no concentration in a particular stock.

• Cost-benefit - only hedge if the benefits outweigh the cost.

• Cut loss - be prepared to sell and cut loss if you have made an error in your analysis and/or valuation.

• Don’t rush - this refers to slowly building up or exiting a position. It is likely that you may look at a stock differently when you are invested.

• More for high conviction - this relates to investing a bigger amount for those stocks with higher conviction.

• Quality of earnings - this relates to the proportion of income attributable to the core operating activities of a business. You ignore any anomalies, accounting tricks, or one-time events.

• Several sectors - diversification is not only about investing in several companies. It is also to ensure that the stocks in the portfolio are from different sectors. The goal is to ensure that there is no concentration in any particular sector.

• SOP - have standard operating procedures.

• Understand management - evaluate management from several perspectives ie as an operator and as a capital allocator.

• Use various metrics - there are many metrics and techniques when it comes to valuation. Adopt a number of them so as to triangulate the intrinsic value.

• 3 Bucket - this refers to an asset allocation strategy where the net worth is spread into 3 asset classes ie liquid, safe, and risky assets.

Pulling it together

• With the permanent loss of capital as risk, you can adopt the risk management process to assess risk and bring it into your investment process.

• Risk management involves identifying the threats, assessing, and then mitigating them. You consider both the likelihood of the event happening and its impact.

• The mitigation measures involved avoiding, reducing, accepting, and transferring the risk.

• There are various ways you can suffer a permanent loss of capital. They can be due to stock market changes, portfolio construction, wrong estimation of intrinsic value, and deterioration of the intrinsic value.

• A risk management framework was used to assess the likelihood and impact of each of the threats. This was then used to compare the relative risk of different stocks.

• The risk management framework was also used to identify the various measures to adopt to mitigate a permanent loss of capital.

Disclosure: I am/we are long "EKSONS" AND "ASIAFLE". I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The 2 stocks mentioned are Bursa Malaysia stocks which I have some positions. But I have no plans to alter my position within the next 1 month.

Disclaimer

I am not an investment adviser, security analyst or stockbroker. The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies. Investments or strategies mentioned in this website may not be suitable to you and you should have your own independent decision regarding them.

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such.