Risk

We believe risk is the prospect of permanently losing money.  This contrasts with most investors and academics who describe risk as the likelihood and magnitude of prices bouncing around.  As such, over the past few market cycles, there has been an increasing obsession with finding ‘uncorrelated assets’ in order to build a portfolio that exhibits as little measured price volatility as possible.  The problem with this approach is two-fold.  First, it presumes that shorter term price volatility equates to risk and, second, it presumes that historical relationships between different asset classes will hold in the future.  Time and again, the second presumption is refuted as historical relationships between assets go haywire (often at just the wrong time).  But more importantly, the first presumption is simply wrong.  Risk is not volatility; it is the prospect of permanently losing money, not a short term quoted price decline.

But before we go further, we need to make one important point:  discussing risk in the absence of a time horizon is meaningless.  An investor’s time horizon is absolutely essential to understanding his or her capacity to handle risk.  If you absolutely need to have access to all of your money instantaneously, then you have a very low time-risk tolerance and the prospect of a short term quoted price decline is your definition of risk.  As such, you should have all of your money in treasury bills.  If, like most investors, you have a longer term horizon, you should measure risk (i.e. the chance of losing money) as a decline in unit price, measured over a reasonable period of time.

So over what time period should declines in unit price be measured?  We believe three years is the minimum period over which to evaluate any investment manager since shorter periods can give very misleading results – a manager may be brilliantly building positions in undervalued companies or may be stubbornly pouring good money after bad in overvalued companies.  Three years is the point at which one starts to cross over from the ‘voting’ to the ‘weighing’ characteristics of the market; although five to ten years is required for the real shift to occur.

Since Turtle Creek’s founding in 1998, there have been 127 three year rolling periods (i.e., Oct 31/98 to Oct 31/01, Nov 30/98 to Nov 30/01, . . .).  Over these periods, the market (as measured by the S&P 500 Total Return Index in C$) was negative 61% of the time.  We, on the other hand, were negative only 11% of the time.

Negative Three Year Returns

S&P 500 TR:	78 or 127 (61%)
Turtle Creek:	14 of 127 (11%)

And lest you think that our negative periods were any more severe than those suffered by the market, the average annual return over our negative three year periods was -7.5% vs the S&P 500’s average annual return of -6.9%.

So, by the numbers, one can see that we have been pretty successful in managing risk.  But just as importantly, this is where all of our money is and we are conservative investors.  We manage risk by understanding the value of the companies we invest in and then constructing a diversified portfolio that, among other things, owns relatively more of the most attractively priced companies.  Put simply, the cheaper something is, the less risky it is.