Dealing With Unrecognized Risks
I previously wrote about key takeaways from Warren Buffett's (Trades, Portfolio) 2023 letter to Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) shareholders. One section that particularly caught me off guard was the guru's revelation he failed to consider the adverse developments in regulatory returns for Berkshire Hathaway Energy. His failure to consider a significant risk echoes a similar mistake made by the late Charlie Munger, who underestimated the competitive risk with Alibaba (NYSE:BABA), a substantial investment for Daily Journal's (NASDAQ:DJCO) portfolio. The inadequate and insufficient risk assessment by both investors raises a pertinent question for every value investor: How can we deal with unrecognized risks?
In this discussion, I will attempt to provide a preliminary answer.
Unknowable risks versus unrecognized risks
First, it is crucial to distinguish between an unknowable risk and an unrecognized one. An unknowable risk is similar to a "black swan" event in that it cannot be identified or objectively measured in advance. Covid-19 could be considered such a risk as it was virtually impossible for almost any investor to objectively assess the likelihood of a global pandemic in any given year. Conversely, an unrecognized risk is one that could have been objectively measured beforehand but was not identified, analyzed or evaluated.
In essence, an unrecognized risk is a knowable, recognizable and quantifiable risk. Yet, for any number of reasons, an investor fails to take it into account. This is the case for Buffett with regards to Berkshire Hathaway Energy, as well as for Munger with regards to Alibaba.
Unrecognized risks can be attributed to many factors. Among the most common reasons why value investors overlook identifiable yet unrecognized risks are:
Stepping out of one's circle of competence. An investor may not have the necessary information, knowledge or expertise to identify all potential risks. I think Munger's mistake with Alibaba falls into this category as he evidently did not grasp the intricacies of China's competitive e-commerce landscape.
Changing business environment. For some businesses, the environment in which they operate may change over time, creating new risks that were not previously present. The emergence of new technologies or changes in regulations are the two most common factors that create new unrecognized risks. This was the case for Buffett's mistake with Berkshire Hathaway Energy.
Lack of complete and accurate information. An investor may understand a business, but may miss a major negative development due to complacency, sloth or insufficient monitoring. An example that comes to my mind is Berkshire's late response to Wells Fargo's (NYSE:WFC) significant issues. Buffett and Munger sure understood the bank, but they were not paying enough attention to assess the magnitude of its issues.
Mitigating the impact of unrecognized risks
The nature of unrecognized risks makes it particularly troublesome for value investors. Even Buffett and Munger, two of the greatest value investors ever, stumbled upon unrecognized risks in their hugely successful careers. The challenge lies in the fact that unrecognized risks often remain hidden, especially for businesses with attractive valuations such as Alibaba or better-than-average businesses such as Berkshire Hathaway Energy.
Faced with this challenge, the most important thing for any value investor is to always conduct thorough research in order to develop an adequate understanding of the underlying businesses. The research process should at least include a careful analysis of financial statements, an understanding of the company's competitive position in its industry and an assessment of management's competency and integrity. Additionally, investors should stay updated on recent industry trends and developments that could have adverse impacts on the business. Without diligent and thorough research, value investors are at risk of making decisions based on incomplete or inaccurate information.
But even with diligent and thorough research, value investors may still fail to recognize an important and recognizable risk. This is when the margin of safety framework comes into play. I think the application of margin of safety should not be not limited to valuation. It should extend to risk assessment as well. Specifically, when contemplating the risks associated with a particular investment, value investors should assume some recognizable and important risks might be missing from the analysis.
The application of the margin of safety framework in risk assessment means value investors should always prepare for the possibility of overlooking important risks and come up with a methodology to deal with such a scenario. For instance, value investors might apply a higher discount rate for businesses operating in specific industries, thereby lowering the calculated intrinsic value. Alternatively, they could reduce the portfolio weighting of companies facing heightened technological and regulatory risks. In an extreme case, a value investor's best option is to stay away from fast-changing and highly regulated industries.
In conclusion, while it may be impossible to eliminate all risks, value investors can take proactive measures to mitigate the adverse impact of unrecognized risks.
Final thoughts
Buffett's 2023 shareholder letter reminds us again that value investors should always behave prudently. By acknowledging the potential for unrecognized risks and implementing risk-mitigating measures to their investment process, value investors can better navigate the ever-changing investing world. As Benjamin Graham shrewdly pointed out, "The essence of investment management is the management of risks, not the management of returns."
This article first appeared on GuruFocus.
