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Risk Framework

Risk is a critical component of our business, and we are fundamentally engaged in risk-taking. However, our approach is guided by two core principles. First, we believe in taking risks only when the risk reward is favorable. Second, effective risk management is possible only when one knows the source of the risk. With this perspective, we categorize risk into three types: Type A, Type B, and Type C risks.

Type A – Permanent loss of capital

  1. permanent loss of capital, meaning after you invest, you lose 80-100% of the capital
  2. Caused by inferior quality of Management (frauds, poor capital allocation, excessive leverage, aggressive accounting, etc.) or business model (disruption risk)
  3. Serious wealth destruction triggered by ignoring/delayed identification of these risks
  4. Forensic/business deep dive can help identify potential risks
  5. Clear NO GO for aforesaid risks despite short-term upside potential
  6. Interesting co-relation
    • Companies which don’t carry a permanent risk of loss(using these filters) are also the ones who have delivered superior returns

Type B – Volatility risk

  • It is the risk of mark to market or volatility risk, meaning, after you invested, you sort of lose temporarily your value of your portfolio
  • Source of volatility is unpredictable comes from macro factors like Geo-political/political issues, liquidity, temporary market dislocation
  • Why do people spend maximum time on it? Because it
  • Creates an illusion of control
  • Ignites a bias to action
  • Gives them a thrill
  • Is sometimes – immediately gratifying
  • This is unpredictable, unmanageable, very relevant risk for a day trader or a leverage player. We don’t do both, hence we don’t spend much time on this.

Type C risk: Underperformance /opportunity loss risk

  • It is risk of opportunity loss, meaning you should have invested into sector A stock A but invested in sector B or stock B thereby generating suboptimal returns.
  • This is a notional risk. What we think it’s a real risk because everybody has a finite pool of capital, right? And hence it’s a real risk.
  • Source of this risk is again two fold; Lack of knowledge & long held human biases

So, whatever we do on risk sits on type A and type C pillars. Type A allows us to protect capital and type C allows us to outperform markets. So, this is our framework of risk.