BUFFETTS BOOKS ACADEMY: INTERMEDIATE COURSE

LESSON 12: WHAT IS FINANCIAL RISK

LESSON OBJECTIVES

1. Differentiate risk and reward.
2. Understand what the baseline value is for risk and reward.
3. Understand what causes financial risks in a business.

LESSON SUMMARY

In this lesson, we first learn about the general concept of risk versus reward. Typically, this implies that if we take on risks, we can get a higher return. On the other hand, we can also risk losing some or all of our investment.

To illustrate, risk straight line going from 1-10 is introduced with 10 being the highest of risk. At 1, we have the absolute lowest risk investment, which is a government bond. The reason why this is perceived risk free is because the government can simply print more money. Contrarily, a corporation would never – in theory – have a problem meeting their debt obligations. At the very top of the risk scale is a Ponzi scheme.

We also learn here for the first time that when we invest, we compare it to the 10 year federal note (it is just a bond), which is our benchmark for investments here at BuffettsBooks. We will return to this several times in other lessons, but the importance of the 10 year federal note should be remembered for now.

Different causes of risk are also examined in this lesson. The first and most common method of financial risk is excessive debt. The main reason for debt is that it speeds up time. For example, the corporation does not have to wait until they have made enough money to buy a given asset. However, you, as an individual, typically can’t afford to pay for your home in cash. Therefore, you save time by taking on a mortgage.

A metaphor from a computer game is used to signal both the benefits and costs of speed. As such, there is no problem in having a mortgage or having a small amount of the presence of debt in a corporation. The key word is manageable. Just as a very large mortgage is very hard to handle – especially if you want flexibility in your personal finances, the same is true for a corporation with a high amount of debt.

Warren Buffett has very strong opinions about debt. He knows that when times are bad, the corporation that has incurred too much debt will suffer, and therefore, he does not invest in leveraged companies.

Another financial risk according to Warren Buffett is price. Even the best asset can be bought at a steep cost and one way to analyze this is by valuating your home. Although it’s a high quality house, there will always be a limit to how much someone else would be willing to pay for it.

The same is the case when you buy a stock. If you pay too high a price compared to the value of the stock, your return will likely diminish. This is also why Warren Buffett is famous for his quote: “Price is what you pay – Value is what you get”. There is no reason to pay $250,000 for a home worth $200,000. A value investor like Warren Buffett does the exact opposite when he buys stocks. He will buy the stock where the value is much higher than the price.

Warren Buffett is also known for his quote on a third type of risk: “Risk comes from not knowing what you’re doing”. While some people have definitely been burned by the housing market, the valuation of a home is something most people still understand. It is different when it comes to stocks that are real companies broken into millions and sometime billions of pieces. Very often, stocks are not bought on a value-based approach where all facts are examined, but rather on emotions. An investor doing the latter is setting himself up for the third financial risk: Not knowing what he is doing.

Warren Buffett’s determination of risk and investment strategy can be found in the Berkshire Hathaway Letters to Shareholders. Berkshire Hathaway is a holding company where Warren Buffett has created a 20% annual return. In his letters he discloses and explains his successful investments alongside the investments where he completely misjudged risk and lost his money. If you want to learn from the best, this is a highly recommended read.

NEW VOCABULARY

Risk
A relative measure of the likelihood of losing your investment. The higher the risk the more likely is it that you will lose some or all of your money in that investment. Warren Buffett’s advice for identifying the three main types of risk:

• Excessive debt
• Paying too high a price compared to the value you get
• Not knowing what you are doing

Debt
Debt generally occurs when you’re borrowing money either because you don’t have it, or you need some extra money to achieve a goal. Typically, debt is incurred when people speed up the process in order to afford whatever they want.

Value
Value is often very different from the price. It is subjective and must be estimated. A value investor like Warren Buffett pays a lower price than the value of a stock or bond.

10-year federal note
The only difference between a note and a bond is the duration of the loan. Bonds with durations of 10 years or shorter are called notes. From this lesson, the takeaway from the 10 year federal note is that it serves as the benchmark for other investments.

LESSON TRANSCRIPT

Everyone has probably heard of Risk vs. Reward. Here is a demonstration to help you think as you take on a more risky investment. First is a marginal amount of risk and reward, while the other is more risk for more reward.

There is more pressure and stress in the latter. Make one little mistake and it is a total collapse. Keep that in mind as you assess your risk vs. rewards. The risk when investing in stocks and bonds is that you could lose a little bit or all of your money, and the reward is you could make money and you don’t have to work hard. As a tolerance of risk, 1 should be the lowest amount of risk for the reward, and that is the 10-year federal net (A bond is for long term like 20 years. A note is for short term like 2 years). Charles Ponzi is an example of 10. All you have to do is assess and think about the amount of risk that you’re willing to assume for each and every investment. Always compare back the 10-year federal note.

We used the 10-year federal note because the Federal Government can simply print more money to meet that obligation. If you take simple cash, for example $100 for a 10-year period, that Federal note will always perform just like the cash because you’ll be making it 2.2% yield as of May 1 on that federal note, while the cash should be absolutely nothing. Regardless of how inflation moves in the future, you will still be doing better in the federal note.

Our bench mark is to compare any other investment, the risk associated with it, and what causes financial risk in an investment.

There are 3 risks:

• Termination
• Overpaying for an investment
• Not knowing what you’re doing

If a company or the local government has debt and you own a share/stock or you supply the loan, you are diving to a great risk. A company has debt, because they want to speed up time.

If a person wants to buy a 300,000-dollar house, but doesn’t have the money yet, he will take a loan. Why? Because he wants to speed up time. He doesn’t want to wait 15 years in order to save enough money to buy that home. Instead, he takes out the debt and speeds up time so he can move into that house right away.

Business is exactly the same thing. A company owns a lot of debt because they want to speed up time and have that machine in order to make that product immediately. They don’t want to wait 5 years to save up money to buy.

Why are my examples bad? Assume you are playing a video game. You have 30 seconds to shoot a little rat running across the string. Here are three different scenarios:

• Normal speed, 10 targets, shot 10
• Fast speed, 14 targets, shot 12
• Super speed, 18 targets, shot 10
• Dash speed, 22 targets, shot 6

On the first scenario, you got it perfect. On the second scenario, it was a bit better because it was faster. You shot 12 out of 14. On the third scenario, it was much faster. You shot 10 out of 18, because the rats were running faster and it was harder to shoot. On the last scenario, you shot only 6 out of 22, because the rats were moving really fast.

In this example, the rat and the speed represent the amount of debt the company is taking on. As the company takes on more debt, the company is actually becoming less productive in the long run. With a bit of debt with the rat just running gradually faster, we performed a tad better. Think about that. If the company has debt, it is fine, but if it’s a lot it’s NOT fine. A lot of risk comes with it. As an investor, it always ends badly whenever you invest on companies with a lot of debt. Always remember this illustration when choosing a company.

Warren Buffett said, “Only when the tide goes out, you discover who’s been swimming naked.” Here, by ‘swimming naked’, he was referring to people who have debt. When the tide goes out, which means when the market collapses, you figure out who’s been swimming naked. These are the people who don’t make it and people who fail.

The second risk is overpaying for an investment. According to Warren Buffett, the price that you pay is the value that you get. Assume that a man sees a house on the market for $200,000. He likes the house so much that he pays $50,000 as a listing price. 1 year later after he paid $250,000, he has to sell the house because he’s moving for a new job. He tries to sell the house but he can’t get any close to the price he paid a year ago. This scenario shouldn’t surprise you because although the house is still the same – clean, safe, and new, the market condition didn’t change. The investment based on the initial price paid is not the quality of the home. The investor paid way too much for the house, so it is a poor investment.

How was the previous example any different from a person in the stock market buying a stock for $25 when it’s only worth $20? NONE. The ratio $200,000 and $250,000 is exactly the same as $25$ for something that’s worth $20. Again, the price that you pay is the value that you get.

The third risk is the danger that arises from not knowing what you’re doing. Why do people value the ownership of a house but the not ownership of a company? It’s simple. People understand the value of the home, but they don’t understand the value of a company. Also, they definitely don’t understand the value of the company when individual shares are broken up to 10,000,000 pieces. That is the true risk. If you’re the person who buys companies and shares and you never look at what their worth, you’re just buying based on emotions and are setting yourself up for buying the $250,000 house. Risk comes from not knowing what you’re doing.

In this lesson, we briefly talked about the difference between risks and rewards. We learned that the 10 year Federal Note is a risk free investment that provides a marginal return. We know that in future lessons, we’re going to use the 10 year note as our baseline value to relatively compare the value of other investments.

When we assess the amount of risk that’s associated with an investment, we learned about three factors that make an investment risky:

• Debt. We learned that as a company increases the amount of debt (or leverage) they use, it typically results in diminishing returns. By avoiding investments that carry a lot of debt, you’ll mitigate the risks associated with any investment.
• Price. Although investors might have the opportunity to purchase a really great business, we learned that the price at which they purchase the asset can actually result in a poor investment. We know that the price is what we pay and that value is what we get. This idea is at the heart of a value based investing approach.
• Knowledge. One of the hardest things for an investor to do is to admit that they don’t know all the facts. Although this may prove challenging, the faster an investor can identify they lack of knowledge or ability to properly account for all the variables, the less risk they’ll assume in any investment.