Money Australia – July 2017

Thedefinitionof“attractive”isalsosomewhatsubjec-

tive and can change over time. In a bear market, it may

simplybethestocksIbelieveofferthemostupside.At

the moment, more than eight years on from the bottom

ofthelastbearmarket,downsideprotectionweighsmore

heavilyonmylistofattractivenessthanmaking a killing.

3

ENVISION POTENTIAL

RISK FACTORS

Nowit’stimetobringriskintothepictureby

imagining and running through risk factors. Warren

Buffettsaiditwell10yearsagowhenlookingtohirea

successor to manage his company’s investments. One

of Buffett’s key criteria was, with his emphasis: “Some-

one genetically programmed to recognise and avoid

serious risks,including those never before encountered.”

I spend a lot of time researching and thinking about

variousriskfactors(someopposedtoeachother)that

mightemerge.AsampleoftherisksIoverlayonport-

folios to test for exposure include pandemics, terrorist

incidents, recessions, inflation, deflation, a property

market crash, another financial or banking crisis, a

25%-plus fall in the sharemarket or severe drought.

4

CONSIDER RISK CORRELATION

The final step is to consider the correlation of

risks that the most attractive stocks on my list

areexposedto.Here’salistofhypotheticalinvestments

ranked purely by their level of underpricing:

T

he excellent bookAManforallMarkets

wasthefocusofMay’scolumn.It’sby

card-counting and investing guru Edward

O.Thorp.Icoveredsomeofthebook’s

lessons previously but there is one key

aspect to Thorp’s success that I want to focus on here,

and that’s risk. Comparing his gambling career with

his time in the investment world, Thorp writes: “Each

requires money management, choosing the proper

balancebetweenriskandreturn.Bettingtoomuch,

even though each individual bet is in your favour, can

beruinous...Ontheotherhand,playingsafeandbetting

toolittlemeansyouleavemoneyonthetable.”

Many outstanding investors advocate concentrating

yourportfolioheavilyonyourbestideas.It’sanapproach

I believe in, but it carries serious consequences if you get

itwrong,whichiswhyriskmanagementissoimportant.

Inthiscolumn,I’llshareafour-stepprocessforport-

folio construction, incorporating the concept of risk

weighting. The first two steps are focused on valuation,

while the final two introduce the overlay of risk.

1

UNDERPRICED. ALWAYS

Themostimportantthingistoonlybuyandown

investments that are underpriced. Overpriced

investments are never welcome in the portfolios I

manage,evenifacademicsinsisttheyadddiversifica-

tion. I’d rather hold cash than an overpriced position.

While this might seem to be part of the “return” side

oftheequation,thereisalsoanelementofriskman-

agement. Overpriced investments always present an

element of price risk. Even in a rising or f lat market,

expensiveindividualstockscanfall.Justasktheown-

ersofformerdarlingssuchasBlackmoresandBellamy’s.

2

RANK BY ATTRACTIVENESS

Thesecondstepistoranktheunderpriced

stocks you’ve identified in order of attractiveness.

The level of underpricing is a subjective but necessary

call. A concentrated investor only has a handful of large

positionsavailableintheirportfolio,sotheymust be

saved for the most attractive investments.

SHARESSTRATEGY

When

markets

have been

kind,itcan

be easy to

forget the

dangers

that might

lieinstore

STORYGREG

HOFFMAN

Toolkit

to test

the risk