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In the Absence of a Market

By August 22, 2023June 28th, 2024featured articles

To buy a share and not have the flexibility to sell it for say, five, ten or even fifteen years would kind of focus an investor’s mind, not so much on the likely returns but on the risks of getting it wrong.

I have always found the three-pronged framework for assessing risk in companies – the business, financial and valuation risks – to be a very useful framework, as it forces the investor to ask better questions about what might constitute risk to an investment.

Business risk, of course, is the risk that a certain company you are considering investing in will not be generating the same level of earnings in five to ten years as it is today.

Financial risk reflects the risk that management adds too much debt to a business such that shareholders’ equity is imperiled in a downturn because either the business fails or management raises new equity (capital) to solve the financial problem, thus diluting existing shareholders’ interests, sometimes fatally.

Valuation risk is the risk that you overpay for the shares to the extent that you lower the subsequent returns available from them.

Business risk appears like an open-ended risk in that any number of issues could derail a business’s future, including economic downturns, the arrival of new competitors, technological advances that make a certain company’s products or services redundant among many other business risks.

Having a competitive advantage of some sort reduces business risks considerably. It’s hard to compete with Coca-Cola in the global non-alcoholic beverages market. Google is the go-to web browser with no new entrant having been able to make any impact on Google’s franchise to date.

Ryanair has developed a low-cost, competitive advantage in the European short-haul air travel market allowing it to gain continuous market share. While that doesn’t protect Ryanair against the frequent downturns in the industry, it does mean they are probably the only European airline that you can be sure will be around in twenty years.

Primark (Penneys in Ireland), owned by the FTSE 100 company Associated British Foods, also has a low-cost competitive advantage in fast fashion retailing that appears to have protected it against the onslaught of online retailing.

The ferry operator, Irish Continental, along with the Swedish ferry company, Stena control the shortest sea routes from Ireland to the UK between them. Again, this doesn’t guarantee growth for either business, but it makes it pretty hard for new ferry operators to enter the market.

Pernod Ricard and Diageo own a collection of iconic spirit brands between them. Consumer brands with decades or more of heritage like Jameson, Middleton Rare, Guinness, Johnny Walker and many others are almost irreplaceable in customers’ minds. This position affords these companies not just protection against newcomers but also pricing power; the ability to raise prices to offset rising costs without damaging the long-term demand for their products.

Investors would think differently, if they had no obvious exit after they had purchased a certain share. Of course, to think like that is to think like the owner of a private business who rarely has an exit option, in the short- to medium-term at least.

Think like an owner of the business and you’ll become a better investor. The risks embedded in long-term share ownership crystallise very quickly when we have no exit option. Only when you understand the risks to the survival of a certain company should you switch to considering a company’s growth prospects, which largely underpin the future returns.

Thinking like this, of course, has an added advantage. It makes it perfectly clear that the volatility in stock markets is not actually a risk at all. No, the volatility you see in markets is only a risk, if you need access to your assets in the near-term.

In fact, volatility in markets is an opportunity, so long as you can take advantage of it which means having spare resources to invest when markets are in poor shape, as it is at such times that much better value – with no additional risk – is on offer.

Having no short-term exit option is a great investment teacher. If you can’t quantify the aforementioned risks, then the age-old lesson applies; diversify widely. Fund structures do that for you and mostly at a reasonable cost.

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Rory Gillen
Founder

22nd August 2023