One of our enduring themes at Retirement Watch is that investors need to manage risks and they’ll earn higher return long-term if they take lower risks. The academic world finally is catching up with this thinking, and it’s moving fairly rapidly into the professional investment world. Take a look at this paper from GMO, a major money manager. The authors point out several rules of thumb of modern finance that don’t hold up when data is analyzed. They urge investors to buy stocks of quality companies, those that have been around for a while and have “moats” and other protection in the form of brand names and other features. They also say higher leverage doesn’t lead to higher corporate profits.
Of course, it should be absolute risk on a forward basis that one seeks to minimize. We differ with many practitioners
in how this is best achieved. The vast majority seem to follow a quantitative approach to risk, obsessed with its
measurement rather than its meaning. Yet, as our colleague James Montier consistently argues, risk is a multifaceted
concept, and it is foolish to try to reduce it to a single figure. Like James, we prefer a more fundamental approach.
We believe, and have to date demonstrated, that the best ex-ante indicator of low forward absolute risk is found not by
studying historical market price data, but through the study of corporate profits. This harks back to the way in which
Ben Graham talked of risk. He argued that real risk was “the danger of a loss of quality and earnings power through
economic changes or deterioration in management.”
Following this logic would argue for a portfolio constructed of companies with high and stable profits, which should,
by controlling “real risk,” result in low and stable “price risk.” Hence one needs a framework for identifying future
corporate profitability. This might seem like Mission Impossible when one considers the truly appalling track record
of Wall Street analysts when it comes to forecasting future profits. However, some classic microeconomic theory can
provide a good starting point.