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The flaws in traditional risk measures

William Browne, New York-based managing director of Tweedy, Browne Company, discusses the flaws in the traditional measures used to monitor risk and explains to Kristen Paech why leverage is the road to financial hell.

The Aramaic word hobha means both ‘sin’ and ‘deb’, and according to the managing director of Tweedy, Browne Company, it suggests that “the road to financial hell is debt”.

The uncertainty of financial markets is the underlying driver behind the value manager and investment adviser’s aversion to leverage and penchant for companies that have above-average dividend yields, an established history of paying dividends and reasonable valuations.

William Browne, New York-based managing director of Tweedy, Browne, agrees with the philosophy that measures used by the majority of the investment management industry to evaluate risk, such as value at risk (VaR), the Gaussian copula function and covariance matrix, are fundamentally flawed.

These formulas drove investment professionals to “heap on debt on a small capital basis because of a false sense of confidence”, he says.

“Mathematical finance is in the business of trying to eliminate uncertainty,” Browne says. “Practitioners thought they could remove uncertainty to such a degree that they didn’t need to spend much time worrying about it.”

However Browne says that rare events are “simply not that rare, they seem to occur with rather constant frequency”.

Investors should accept that there is never going to be certainty because markets are driven by people and people are “reliably unreliable”, he adds.

The attitude of invincibility, or “99 per cent confidence level” that uncertainty had been taken out of the equation justified enormous amounts of leverage to turbo-charge returns, and ultimately led to the downfall of the likes of Lehman Brothers and Bear Stearns, Browne says.

The traditional risk measure of VaR failed to identify the risks inherent in the investment banks prior to their collapse.

According to Browne, in February 2008 shortly before its collapse, Bear Stearns had a VaR of $62 million.

In August 2007, it had $400 billion in assets, $40 billion of which did not have a quoted market and $13 billion in capital. In other words, its gearing ratio was about 31 to 1.

Meanwhile, shortly before its demise Lehman Brothers had a VaR of $85 million. In February 2008 it had $785 billion in assets and $25 billion in equity, so was also leveraged about 31 to 1. Its short-term borrowings were $520 billion and long-term borrowings were $125 billion.

Rather than rely on leverage to boost returns, Tweedy, Browne invests according to five key principles outlined in a paper titled “What has worked in investing” that was penned in 1992 but updated this year.

These are: Low price in relation to asset value; low price in relation to earnings; a significant pattern of purchases by one or more insiders (officers and directors; a significant decline in a stock’s price; and small market capitalisation.

“If we can’t turbo-charge our returns by leverage, what we have to do and what we are driven to do is to look for even larger discounts,” Browne says.

“In essence, what you need to do is get a substantial discount between the price of a security in the marketplace and what the business is worth.”

A common misconception about value managers is that they are “financial scavengers”, Browne says, adding that the notion is “at best incomplete and for the most part inaccurate”.

“What we’re trying to do is buy good businesses,” he says. “We are trying to build a portfolio of 40 to 50 bets… or businesses that have financial characteristics in common. We look for diversification by business, by industry and by country. We have a healthy appreciation for the inability to predict the future.”

In line with this, Browne says the company does not try to buy the 10 best businesses, instead looking for high probability factors based on strong data.

“The only thing you can control is strategy and implementation,” he says.

Tweedy, Browne was founded by Forest Birchard Tweedy in 1920 as Tweedy & Co., a dealer in closely held and inactively traded securities. The firm’s 89-year history is grounded in undervalued securities, first as a market maker, then as an investor and investment adviser.

The firm has offices in New York and London, and counts 55 staff, with 13 looking after securities

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