Why A “Safe” Stock May Be Risky While A “Risky”

Howard Marks Explains Why A “Safe” Stock May Be Risky While A “Risky” Stock May Actually Be Safe

Howard Marks has drawn a masterful distinction between “fundamental risk” and “investment risk” and explained that while a top-quality stock may not have “fundamental” risk, it carries an “investment” risk if we overpay for the stock. The vice-versa is true for a low-quality stock quoting at throwaway valuations, he says. The moot question is how we can apply this wisdom to a real life situation

If you ask a novice investor to point out a “risky” stock, he will point to a stock which is hitting 52-week lows e.g. realty stocks. If you ask him to point out a “safe” stock, he will point to a stock hitting 52-week highs such as Page Industries, Eicher Motors etc.

The situation is that the novice investor equates “risk” and “safety” with the way that the stock price is moving. Also, novice investors equate price with quality. They believe that a high-priced stock is a quality stock while a low-priced stock is a junkyard stock.

Howard Marks, one of the foremost authorities on value investing, has sought to clear this misconception.

In his latest memo titled “It’s not easy”, Howard Marks explains that investment risk resides most where it is least perceived, and vice versa. He points out that when everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. All optimism is driven out of the price. In contrast, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky. As no risk is feared, there is no “risk premium” attached to the stock and this makes it very risky.

Howard Marks emphasizes that most investors make the mistake of regarding “quality”, as opposed to “price”, as the determinant of whether something is “safe” or “risky”. Thereby, a top-quality stock quoting at an exorbitant valuation is still deemed to be “safe” while a low-quality stock quoting at rock-bottom valuations is still deemed to be risky. But high-quality assets can be risky, and low-quality assets can be safe. It’s just a matter of the price paid for them, Howard says.

Howard Marks also points out that novice investors fail to distinguish between “fundamental risk” and “investment risk”. While a quality stock may have no “fundamental risk” it may have an “investment risk” owing to its high valuations. On the other hand, a stock with poor fundamentals may have no investment risk because all the risk may already be priced in.

“The bottom line is simple: the riskiest thing in the world is the widespread belief that there’s no risk. That’s what most people believed in 2006-07, and that belief abetted the careless behavior that brought on the Great Financial Crisis. Only an understanding that risk was high could have discouraged that behavior and rendered the world safe. I call this “the perversity of risk”Marks says.

Now, the all-important question is whether we can apply this wisdom to real-life stock buying. The answer is that the bombed out realty sector is a text-book example of what Howard Marks is talking about. The sector is so much in the doldrums and the stocks are so lowly priced that there is virtually no “investment risk” attached to them. So, an investor buying realty stocks now and waiting patiently for the tide to turn is not exposed to much investment risk. On the other hand, he stands to make bumper gains when the tide turns and realty stocks go back into demand. This is the advice we have received from Ramesh Damani, Porinju Veliyath and Nilesh Shah.

Happy Investing

Source:Moneycontrol.com