How do we analyze risk?

Dear investors,

There is far more glamour in seeking to understand how a company can be extremely successful than there is in investigating everything that could go wrong with it. Estimating the potential for gain is also usually less laborious. The plan for success is already offered ready-made by the executives of listed companies, in elegant presentations and sophisticated events. Meanwhile, the business's fragilities and the risks of the strategy take a backseat.

However unexciting they may be, the risks of each opportunity should be the main focus of a prudent investor, as not suffering significant capital losses in risky investments is a necessary condition for achieving high returns over a lifetime, across multiple investment cycles.

Adequately controlling the risk assumed is more important and more difficult than identifying major potential returns. For this reason, most of the time we spend developing a new investment thesis is dedicated to mapping possible negative events and estimating potential losses in those adverse scenarios. Next, we will share some of the principles we use to guide our risk analysis process.

Nature of Risk in Equity Investments

The great difficulty in dealing with risks in variable income (or 'equities') is how dry and subjective the topic can be. In theory, it would be possible to calculate the risk of loss that any given event represents by multiplying the probability of the event occurring by the negative impact it would have on the company's value. In practice, mapping all possible negative events is not easy, data is almost never available to calculate their probabilities of occurrence, and the negative impact caused by them is quite uncertain.

To adequately map risks, a blend of knowledge from past cases and creativity is needed to imagine what could happen in the future, even if it has never happened before. There are multiple paths to failure and it is impossible to be exhaustive in this mapping, but the goal of identifying the most relevant threats is achievable.

The probability of each event materializing and its negative impact on the company's value are almost always estimated with highly incomplete data, filled in with a healthy dose of subjective judgments. Generally, it is not possible to achieve a degree of precision beyond rough classifications such as: high, medium, or low probability.
One must also consider the influence of time on the probability of certain events occurring. The longer the horizon, the higher the likelihood of a latent risk materializing. For instance, the probability of a person tripping on any given day is low, but the probability of tripping at least once in the next ten years is quite high.

In summary, risk assessment is a task with a poorly defined scope, it is complex, and is carried out without adequate data. Therefore, it is the most 'artistic' part of the investment activity, and the most difficult to translate into a Cartesian method. The following considerations have this backdrop and are not intended to be prescriptive.

Perpetuation of Demand

The first layer of risk to be assessed is the possibility that the demand served by the business decreases or ceases to exist, thereby condemning all companies operating in the same sector.

The most obvious reason why this can happen is technological evolution. For example, whale oil was an important product in the 19th century, used as fuel for oil lamps, as a lubricant, and as a waterproofing agent. Demand for this product completely disappeared. It was replaced by kerosene, and later by electric lamps, for lighting, and by synthetic lubricants and waterproofing agents, which were cheaper and more efficient.

Regulatory changes can also cause a sudden impact on the activities targeted by the new rules. Asbestos tiles were used for decades in civil construction until it was discovered that this substance caused serious health problems for the workers involved in its mining. Several countries banned the commercialization of products made with asbestos, and companies specializing in this area were hit hard. In Brazil, this is what happened with Eternit.

Sometimes, the motivator for the decline is a pure shift in public preferences. In the 19th century, top hats and suspenders were quite common accessories in men's clothing. Today, they are practically extinct. Explanations for what may have caused certain changes in popular fashion emerge a posteriori, but it is practically impossible to predict these movements in advance.

The general consumption pattern can also change due to shifts in the demographic profile. For instance, it is to be expected that the demand for children's products will decrease in regions with a low birth rate.

These examples are not exhaustive, but they illustrate the central concept well. We must reflect on how robust the demand served by the analyzed business is. If there are no longer any customers, operating with excellence and staying ahead of your competitors will not hold much value.

Competitive Threat

The second layer of risk is the possibility of the company being surpassed by its competitors and losing ground within its economic segment. To address this concern, the critical step is to evaluate whether the target company possesses competitive advantages. The metaphor that best explains this concept is the famousmoatof Warren Buffett, the moat that surrounds a castle to prevent the enemy army from approaching the walls, making invasion difficult. Competitive advantages are factors that prevent competitors from conquering your customers and, thus, invading your market position.

In sectors where there are no relevant competitive advantages, the results of the involved companies tend to fluctuate around a level that remunerates the capital employed at the average rate of return for the economic segment. It is possible that a company led by a group of atypically talented executives may remain above this level for some time, but constant aggression from different competitors tends to, sooner or later, damage the business and make its results mediocre again.

This makes investments in companies with atypically good results in sectors without competitive advantages risky, even if it is not possible to identify the specific reasons why the company might lose ground. High returns always attract competition, and there are multiple possibilities for attack. A competitor might start a price war in pursuit of a larger market share, a slightly superior product might emerge and attract customers, or a change in input prices might temporarily benefit those who held a certain inventory level. Without moata few audacious soldiers with ladders can already succeed in invading the walls during the night and causing some damage

When a company has clear competitive advantages, the projection of its results can be done with greater assertiveness and the chance of success in the investment is substantially higher. The risk limitation related to the moat is just as relevant as the pricing power that allows the company to sustain returns above its cost of capital.

Quality of Governance and Capital Allocation

A third layer of risk comes from the possible misallocation of the profits generated by the business. Minority shareholders of a company can only be remunerated in two ways: through the distribution of profits in the form of dividends, or through the appreciation of the shares, which implicitly requires the allocation of profits into something that the market understands generates value. If the cash generated from operations is poorly allocated, excellent profits can be completely wasted and the final return on the investment may be poor.

There are several forms of capital misallocation. The company might invest in exaggerated expansions that lead to idle capacity for years. It might invest in new business segments with no clear synergies with its core activity. Acquisitions might be made at excessively high prices. The cash might simply be retained and invested in fixed income, yielding a return below what shareholders would desire.

Besides these examples of 'legitimate' use, there are possibilities for misconduct. For example, controlling shareholders may assign executive or board positions to themselves with compensation far above market practices, or they may drain company resources through related-party transactions. If these practices are too abusive, they may be classified as a crime, but there is a gray area where it is still possible to harm minority shareholders without infringing upon the cold letter of the law.

The best way to evaluate this type of risk is to observe the historical behavior of the controlling shareholders and the executives running the business. What one should look for are competent partners whose interests are aligned with yours.

Pricing Error

Besides the risks inherent to the business itself, there are also those related to the investment decision. The main one is overestimating the company's intrinsic value and paying too much for its shares, due to some judgment error committed when projecting the business's results. We will discuss some examples of common errors.

In a sector subject to long-term cycles, results during the good phase of the cycle may draw attention, and projections might be made starting from an above-average revenue and profitability base, thus perpetuating atypically favorable indicators as if they were part of the business's normal condition. To avoid this mistake, the way forward is to evaluate the longest possible period of historical results. When there are indications of sector cycles, it is important to understand their dynamics and judge which phase of the cycle the company is currently in. The best moments to invest in such businesses occur during the bad phases of the cycle, when the tendency is to underestimate the business's true value, and the company's shares are usually cheap in the market.

Another pitfall is basing the thesis on a complex narrative of how the company will improve its results in the future. Indeed, there are situations where companies shift to a new level, and identifying them early generates very valuable opportunities, but such theses carry a much greater risk than investing in a simply cheap company, without anything different needing to happen in the future for the business to be worth more than the current price. In theses that rely on 'value triggers,' the simpler the logic involved in the predicted events, the higher the probability that the prediction is correct. Complexity can create a certain intellectual elegance, but the more elements that need to align for the thesis to succeed, the greater the risk of something different happening and frustrating the predictions.

A more subtle error is believing that sustainable competitive advantages exist in a business that has produced very good returns for a few years, even when one cannot clearly explain how these competitive advantages function. This leads to underestimating the business's real risk level and projecting a stability of results that is unlikely to be maintained for many years. When the company experiences a bad period, the thesis that sustainable advantages exist dissolves, and the shares may never reach the value initially imagined.

To deal with these pricing error risks, we use the good old margin of safety. Even with reasonably conservative value estimates, we only purchase shares that are substantially below the price we believe to be fair for the business. This precaution protects us from eventual errors in judgment, and if no mistakes are made, the return on the investment tends to be even better than the target for the thesis.

Closing

There are those who argue that the risk of investing in companies can be measured by the volatility of their share prices, but we hope this brief discussion has clearly illustrated how simplistic that idea is. Likewise, it is also simplistic to believe that higher returns can only be achieved by taking on more risk, as if the market were capable of measuring, precisely and consensually, the risk level of each business.

In practice, two investors may have very different perceptions of risk regarding the same stock, even when faced with the same information. Whoever gets closer to reality will have a clear advantage in evaluating the opportunity and, consequently, tends to generate better returns.

Over the years, we've refined a series of details in our internal processes to ensure greater discipline and better quality in the subjective judgments involved in opportunity analyses. This improvement process is continuous. We periodically review our practices, always seeking to generate superior returns with the lowest possible level of risk for the capital under our management.