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Two fundamental tenets of modern portfolio theory are the notion of diversification and that the only risk that matters is beta. Rather than holding one or a few stocks, investors instead should hold a large basket of stocks. According to the theory, diversification helps investors minimize risk as most of the company-specific risk evaporates in a well-diversified portfolio.

The notion of diversification, however, assumes that risk can be measured and we know how to measure it. Events over the last few years have cast doubt on how risk should be measured and have forced many believers in modern portfolio theory to reassess their models and risk metrics.

Value investors understand that risk cannot be accurately measured. That is why they developed the concept of margin of safety – not buying a stock unless it falls significantly (about 30 per cent) below its intrinsic value. This provides a mechanism for reducing risk which is totally distinct from diversification. In addition, value investors manage risk by carefully examining why they are buying and what they buying.

A value investor's checklist looks something like this:

  • Always have an entry price and an exit price -- and a strategy to be followed religiously. Value investors know their circle of competence and stick with it. They decide whether they are more comfortable investing in low P/E stocks or the stock of companies that have a competitive advantage and a dominant market position. .
  • Deal with less-followed stocks. These are the stocks that are not yet discovered and operate under the radar of large institutional investors and which, for this reason, are most likely to be undervalued.
  • Be alert to the possibility that they must not get carried away by their emotions – panic and exuberance, which hurt the performance of the average investor. Value investors do not like to make impulsive decisions. They try to be analytical; they discuss ideas with knowledgeable friends, and they have checklists that they stick to.
  • Act independently and rely on their own in-depth homework. Value investors are aware that CEOs, portfolio managers, securities analysts and rating agencies may have conflicts of interest -- and they know, as a result, and that no one is watching their back. This is their own responsibility.
  • Trust the management of the companies they invest in – their integrity, knowledge and experience. Value investors need to know that management is working for the shareholders, not for themselves, and have skin in the game.
  • Follow what companies do. If the company is buying back its shares, it is a good sign, if the company is selling shares in the market, it is not. Value investors also track what experts and insiders do. If they are buying shares in a company, it shows confidence in the company’s future, if they are selling, it does not.
  • Make sure that a company’s assets are solid and of good quality, if they are buying because of the company’s asset value.
  • Value investors also examine whether current management be able to manage these assets efficiently to realize adequate cash flows -- or will the company will need new management? What is the likelihood of this happening?
  • If they are buying because of the company’s cash flows and earnings power, value investors make sure that the cash flows and competitive advantage are sustainable and the likelihood of impairment is quite small.

These rules and steps seem to be more important than diversification in controlling and managing risk. We have come full circle to the value-investing concept of risk, and it is the Great Recession and panic of the last few years that are responsible for this.

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Ivey Business School, Western University.

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