Global Corospondent - April 2017

Quarterly Publication - April 2017

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Karl Leinberger

Karl Leinberger

Karl is Chief Investment Officer (CIO) and manager of Coronation's Houseview strategies. He joined Coronation in 2000 as an equity analyst, was made Head of Research in 2005 and became CIO in 2008. Karl has 24 years' investment experience.

“Competition can be pretty intense when your competitors play like they can never get hurt.” – Seth Klarman

“Our predictors may be good at predicting the ordinary, but not the irregular, and this is where they ultimately fail … What matters is not how often you are right but how large your cumulative errors are. And these cumulative errors depend largely on the big surprises, the big opportunities.” – Nassim Taleb

The primary objective in investing is to deliver the best risk-adjusted returns possible. Since return and risk are two sides of the same coin, an interrogation of one without a full understanding of the other is meaningless (and dangerous).

Return is, of course, the easy one. We all know what returns any given security, portfolio or fund manager has delivered in the past. Although future returns are a guess (albeit an educated one), historic returns are fact.

Risk is another story. Winston Churchill once described Russia as a riddle, wrapped in a mystery, inside an enigma.

He could so easily have been speaking on the topic of risk. I say this because:

  • Opinions differ on what risk is.
  • Measuring it presents some challenges
  • In contrast to return, risk remains an opinion as much after the event (ex-post) as it was before (ex-ante).


In financial theory, risk is typically defined as volatility. It is this axiomatic assumption we have to thank for the plethora of betas, Sharpe/Sortino ratios and tracking errors we have in our industry. At Coronation, we disagree. We define risk as the possibility of permanently losing capital. Warren Buffett has this to say on the distinction, “… now if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, then its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million.”

The irony is that risk (of losing money) is often highest at times when volatility is low and complacency abounds. A Minsky moment refers to the risks that often bubble under the surface in extended periods of prosperity. In this environment, asset values typically rise. This often leads to increased confidence, which then fuels speculation and increased levels of leverage. Good recent examples of this include the US housing bubble and the commodity bubble in the mid-noughties. On both occasions volatility was at historically low levels at a time of great risk (of losing money) to investors.

The conventional definition of risk implies that a portfolio full of cash has high active risk and the likelihood of a high tracking error. We would counter that the risk of the investor losing his/her money is low.

I should qualify my comments by saying that I think that volatility does have some informational value. I even think that it gives some indication of the riskiness of a security or a portfolio. But I do not think it is a proxy for risk, and I certainly do not think that volatility equals risk. I think the reason the investment industry picked the volatility definition of risk is its lack of ambiguity. Seth Klarman, head of Boston-based hedge fund Baupost Group, recently said, “Wall Street is a place that highly confident people go to work.” He could have added ‘highly numerate’ to that description.

Our industry is full of highly numerate people – and for the person with a hammer, every problem looks like a nail. Volatility is a number that is easy to understand and easy to observe. It does not enter the murky realm of opinion (which the alternative definition does). Volatility is a hard fact, and I think that is why our industry backs it.


The bad news is, I do not think one can.

Fortunately, as American baseball legend Yogi Berra said, you can observe a lot just by watching:

  • Returns over the very long term. Although returns achieved over a short assessment period reveal little, inadequate risk management should be exposed over long periods. The bad news is that I think the required assessment period is beyond the patience of most observers. (I am thinking here of at least 10 years.)
  • Inflection points in major cycles. As Buffett so famously said, it is only when the tide goes out that you see who was swimming naked. For example, high exposure to US financials or commodity stocks in the mid- to late-noughties looked prescient at the time, but was subsequently exposed as momentum investing when the cycle turned – with little regard for the risk of losing clients’ their money, permanently.


Sometimes, explanations can be more helpful than definitions. My favourite explanation of risk is Elroy Dimson’s: “More things can happen than will happen.”

Human beings are consummate storytellers. Even in an impartial telling of history, we tend to give too little recognition to the fact that while events played out in one way, they could so easily have played out in another. Nothing ruins a good story more than the spoilsport who dwells too long on an inconvenient nuance or the role that happenstance played in the final result. How different would the world we live in be had Adolf Hitler or Mao Zedong not been born, or had the Bolsheviks not prevailed in what was a fragmented and disorganised Russian revolution?

Although our brains are wired to think that the passing of time reveals all, we need to keep reminding ourselves that it does not. All we ever get to know is which one of the multiple possible sequences of events that could have played out actually did, and who profited from that coincidence. While the passing of time may reveal some of the risks that were lurking beneath the surface, we never get to know what all the risks were and how easily they might have come to pass.That is why I say that although returns will always be a fact, risk will always be an opinion. It is something to think about in an industry obsessed with performance league tables that tell you exactly what returns were delivered, but nothing about the risk taken to deliver them.


Managing risk is not something that you should have to clear at the final hurdle in an investment process. We believe it needs to be woven into the DNA of the process, as we endeavour to do in ours.

1. In the research process:

  • Through a strong valuation discipline (i.e. paying less for assets than they are intrinsically worth) and a long time horizon (i.e. looking through the cycle). Together, these are a great defence against the risk of getting sucked in at the top of the cycle, when prices are high and the risk of permanent capital loss is pronounced.
  • Through a bias to quality. We demand significantly higher margins of safety for poor-quality companies, because high-quality companies generally surprise with their growth over long periods and tend to provide the best downside protection in tough economic times. In times of adversity, it is the poor-quality companies that suffer most. High-quality companies are more resilient, and often come out of tough times in a competitively stronger position than they went in with. There is no doubt that this quality bias has resulted in us leaving some return on the table over the years (a situation we are very comfortable with). We will always take a low-risk 30% over a high-risk 50% return. A good example would be gold stocks, which have presented many compelling trading opportunities over the years. We have missed all of them, because we fundamentally think that they are cyclical, low-return businesses that can always halve just as easily as they can double.

2. In the portfolio construction process:

  • We spend as much time thinking through portfolio construction as we do researching securities. Knowing what weighting to give a security is just as important as identifying which securities deserve to make it into the portfolio. We have spent years refining our own proprietary tools to understand overall portfolio positioning, exposure to key risk factors and the risk of unintended bets in a portfolio. The research process will always be the first defence in the risk management process. The portfolio construction process may be a little less sexy and more difficult to articulate, but its contribution is just as significant.
  • We believe in diversification. One often hears Buffett’s famous comment that diversification results in ‘diworsification’. I (respectfully) believe that quote to be somewhat misinterpreted. The ‘benchmark hugger’ that owns everything in the index clearly adds no value and does nothing but ‘diworsify’. However, we believe that a diversified portfolio of undervalued assets is the best defence that any investor has against an uncertain future, and markets that eventually humble us all. For this reason, although our portfolios will always represent the high conviction views coming out of our research process, they will always seek to achieve diversification across sectors, geographies and asset classes (where possible).

3. In our cultural values:

  • Through a team-based investment process. It is the job of every person in our team to challenge the Coronation portfolio DNA that underpins all our portfolios. As an investment house that has not hedged its bets through multiple teams, boutiques or investment styles, we have no other horses in the race. We simply cannot afford for a low-probability, high-impact event (Nassim Taleb's ‘black swan’) to derail our portfolios.
  • We have deep respect for the fact that no one knows the future. It is a key principle that underpins our investment process. As was appropriately articulated by economist Edgar R. Fiedler, “He who lives by the crystal ball soon learns to eat ground glass.” Although we value securities and construct portfolios using a base case scenario, we continually stress-test those assumptions with alternative scenarios.

Ultimately, all investors are judged by their results. A good investment process and an experienced team certainly help, but ultimately it is the runs on the scoreboard that count. We understand this. But at the same time, our clients can find comfort in the fact that we do not get sucked into the temptation to push for returns at the expense of risk. In fact, the converse is true. We live by the maxim that it is often what you get wrong, not what you get right, that defines your long-term track record in investments. For this reason, we leave return on the table every day in pursuit of achieving robust and anti-fragile portfolios that are your best defence against the uncertain world we live in.