You cannot manage a return, only risk

In south-eastern Europe, a people group exists with a peculiar perspective on time. When in conversations referring to the past, they point with their index finger straight forward, and when they talk about the future, they point with their thumb over their shoulder backward. They understand that the past is visible, but the future is not. The future is behind you. You cannot see the future. You can look down a road, from where you came, to the past. And some of what you see in the foreground, the recent past, is clearly visible but the further you look down the road the fussier things appear. The past is like that. The further we look to the past the less we see.

Napoleon Bonaparte said: “history is an agreed upon fable.” Human beings have the tendency to create a warped narrative about the past. We do so to explain our part in how we got to where we are. We make excuses. Politicians create a narrative about the past in support of their ideologies.

And yet everything we claim to know about the present is made up of information about the past. As a result, our grasp of the present is tenuous at best. What we do know, and I think most people will agree, is that trouble comes. Brian Tracey, author, and world renown speaker said: “in life you will have ups and downs, and occasionally you will also have a crisis.”

When once pressed by the media about what would happen to stock markets, Warren Buffet, famous investor, and founder of Berkshire Hathaway said: “I think the markets will go up and down.”

All we can be certain about is that the future will include ups and downs. No one can tell you what return on investment you will receive from any investment, in any asset class, ever. Because no one knows the future. You cannot manage or massage a return on an investment. No one can. All that you can and must do is to manage risk.

What is risk? In simple terms, risk is the chances that things won’t work out the way you expect. Your expectation of the future is invariable based on your experience of the past.

Asset managers present prospective investors with historical data about investment returns over different investment terms. If you download a fund fact sheet of a collective investment portfolio, from an asset manager’s website you will notice that the fund fact sheet reflects, among other things, a graph depicting the historic investment returns of the portfolio. You will also notice that the investment return is seldom a straight line. The graph will show how the investment portfolio value increases and decreases over time. This variance, the ups and downs, is called the volatility of the portfolio. Volatility is a measure of risk. The first thing asset managers will say to you is not to rely on historical data to make your investment decisions, which is hilarious because historical data is all they show you!

A person looking to invest in a business has a very similar experience. The investor looks at the information contained in the business’ financial statements which are by nature historical information. An inexperienced investor base investment decision on historical data. The investor considers the past performance figures as a reliable predictor of future profits. A big mistake.

An investor looking at the financial results of a taxi operator in Chicago at the end of 2011, might have concluded that the business represents a good investment. Many taxi operators at the time presented strong financial results over the preceding years. But in April of 2012 Uber launched its taxi hailing services in Chicago which quickly led to the demise of many a taxi operator in the city. The taxi industry failed to recognize the risks posed by advances in a seemingly unrelated technology.

Too much emphasis is placed on chasing investment returns, and too little attention is given to investment risks. It is easier to not lose money than to make money. Top investment professionals understand this principle. I remember years ago, when employed by a multinational asset manager, I attended a seminar where Pete Major presented. Pete, a Canadian, had been a mine boss and later become a portfolio manager specializing in the mining and resources sector. Pete said he had three rules about managing other people’s money:

Rule one – Don’t lose money.

Rule two – Don’t lose money.

Rule three – Refer to rules one and two.

Pete later went on to manage Mark Shuttleworth’s money. Mark Shuttleworth is a South African born, British entrepreneur, and the first South African to travel to space. Shuttleworth is a highly successful entrepreneur and the founder of Canonical. His personal wealth is estimated at approximately ￡500 million.

Successful investors, and by implication entrepreneurs are conservative.

Focus on creating value for customers, suppliers, and shareholders. Implement best practices in your business. And the profits will come. Profits are the fruits, not the roots. Don’t wase time and energy fretting about profits, manage the things you have control over. Manage risk.

When I look at a business as a prospective investment opportunity, I am much less concerned about historical data about profits. I look for valuable assets and I want to understand what risks the business faces. What steps have the business owner taken to manage risks and what steps can a new owner take to achieve the same end?

The nature and potential severity of risks depend on the type of business, the industry, the market, and geography in which the business operates, amongst many other factors. Consider a wholesale business. Use its trade cycle and duration as a frame of reference. The business procures, and then store stock in inventory. Then the business sells stock which may entail distribution of consignments to customers. After which the business must collect payment from its clients. What are the risks inherent in this process?

Consider Procurement. What if the supplier fails to deliver? What if the stock is imported and the currency moves against the importer resulting in the cost of stock increasing, which impacts the profitability of the trade? What if the Houthis attack ships off the coast of Yemen, prohibiting cargo ships from using the Suez Canal and resulting in weeks long delay of deliveries of stock? An importer may use forward cover to mitigate the effect of adverse currency fluctuations. A business may take a decision to diversify its supplier base to decrease its dependency on imports from one part of the world.

A few years ago, one of my clients went belly up. Climent was an electrical contractor. A highly qualified and skilled business owner. Over the preceding years he developed a reputation for dependability and grew his business into a well-oiled machine. Then Climent secured a contract from a local municipality. A big contract promising big profits. A contract too big for his business to handle. Don’t get me wrong, Climent had the skills and the capacity to fulfill the requirements of the contract, but only just. The business became wholly dependent on this one customer. But the municipality, like so many local authorities in South Africa, was infected with corrupt officials. When he refused to pay bribes, the corrupt officials frustrated every effort for Climent to get paid. His business went bankrupt, and Climent lost all his assets. Neither the profit and loss statement, or the statement of financial position, or the cashflow statement would have alerted a potential investor to this risk. But and this is a harsh thing to say, Climent should have known better. His focus on profit blinded him to the risk.

Summary

Don’t waste your time trying to manage a return on investment, wisely use your time to manage risk.