1. Action
Anything that makes us want to move is a risk, because the move is usually the mistake.
A buy or sell action taken by the portfolio manager for reasons other than a “material and long-term” change in durablility of earnings or future cash flows.
Watching Bloomberg or any financial news.
Following Pied Pipers, whether on a screen, in a newsletter or in a group chat.
2. People and Structures
The people running a business, and the way they are paid, decide how much of its cash ever reaches us.
Managements that mislead, whether by statement, by omission or by habitual optimism.
Poor incentive structures. Pay tied to size, activity or a share price rather than to per share cash generation.
Managements whose interests are not aligned with ours as owners.
3. Risks to our pro-rata share
A wonderful business can still deliver a poor result to us if our slice of it keeps shrinking. Compensation paid in stock and dilution that materially reduces our return are risks in their own right, independent of how good the underlying business is. We treat a share count that climbs every year as a permanent charge against our cash flows, because that is exactly what it is.
4. The risk between our left and right ear
Our biases create perceptual distortions, and a distorted view of a business is far more dangerous than a falling quote. We watch for greed, for overconfidence, and for the feeling of being the smartest person in the room, which is usually when bad decisions are made.
A related risk is trying to define risk without the subject matter expertise to do it. Assessing geological risk in an exploration project is the obvious example. If we do not have the expertise, we either acquire it, rent it from someone who has it and has skin in the game, or we pass. A confident opinion formed without expertise is a folly.
5. Liquidity and leverage
Holding less than 10 percent of the portfolio in US dollars, treasuries or another genuinely liquid instrument is a material risk.
6. Complexity
Complex business models, and anything we do not understand. Complexity is itself the risk, because it prevents us from seeing the other three.
7. What risk is not
Most of what the industry calls risk is not risk to us.
A drawdown with no fundamental change to the durability of future cash flows.
Volatility.
Perceived risks arising from macro forecasting.
Short term returns, and the outcome of the market’s voting in any given year.
What defines our return is the 10 to 15 year outcome, which is the weight of the business rather than the vote on it. We do not treat market risk, drawdowns or any other factor that leaves expected pro-rata cash flows intact as a risk at all.