How We Define Risk

For much of the investment industry, risk is defined simply as volatility – how much a stock’s price fluctuates over time. By this definition, the elevated volatility experienced during the first quarter means risk increased. We disagree.

One of the biggest flaws in using volatility as a proxy for risk is that it is backward looking. Volatility, standard deviation, beta, and other similar measures are all calculated from past price movements. A historically volatile stock is therefore viewed as riskier than one that has been more stable. But the past does not predict the future and can sometimes be severely misleading. We believe that intelligent investing should beforward looking, not backward looking. The relevant question is not how much a stock moved in the past, but whether the underlying business is likely to be worth less in the future. A rearview mirror is a poor tool for navigating the road ahead.

There is one important caveat: time horizon matters. The shorter an investor’s time horizon, the more damaging volatility can be, regardless of the cause. An investor who needs cash in a month faces real risk from a price decline even if the business remains fundamentally sound. But over a five-, 10-, or 20-year horizon, day-to-day price fluctuations matter far less, and the growth of underlying business value matters far more.

If you operate with a long-term business owner mindset like we do, true risk is not volatility. True risk is the permanent impairment of capital – a permanent loss of fundamental business value, usually caused by fragility in the business model, the balance sheet, management actions, or the price paid.

Where We Get Our Information

Short-term stock price movements tell us virtually nothing useful about the future or about true risk. They simply tell us how other market participants are currently evaluating future uncertainty today. We get all our useful information from the underlying fundamentals of each individual business – its competitive position, cash flows, balance sheet, and management decisions – not from the daily fluctuations of its market price. These are the drivers of intrinsic value over time.

This reflects a critical distinction in our investment philosophy: the difference between market value and intrinsic value. Market value (the stock price) can be influenced by many forces unrelated to long-term business fundamentals, such as investor emotion, investor or index fund repositioning, and computer-driven algorithmic trading. Intrinsic value, by contrast, is ultimately determined by the economic success of the business itself. Over time, this success will be reflected in the stock price. As Warren Buffett has often repeated, “Price is what you pay. Value is what you get.” The two ideas are distinct –and conflating them can lead investors to erroneously draw long-term conclusions from short-term noise.

“The relevant question is not how much a stock moved in the past, but whether the underlying business is likely to be worth less in the future. A rearview mirror is a poor tool for navigating the road ahead.”

Risk in Context

Viewed through this lens, we can better frame the two key developments that dominated much of the media discussion during the quarter.

While AI is expected to improve the productivity of many businesses, it is a genuine risk to many others. This is not because it caused stock prices to decline, but because it has the potential to permanently erode the business models of companies that cannot – or will not – adapt. Technological disruption is not new. The history of capitalism is littered with it. Traditional retailers who could not adapt to the internet went out of business, and newspapers, once considered among the best business models in the world, have been decimated over the last few decades. Even though the pace of disruption feels faster today, disruption itself is a permanent feature of competitive markets and a crucial driver of human progress.

The geopolitical developments in Iran represent a different kind of risk entirely. The long-term implications for businesses are still to be determined as hostilities play out over the coming weeks or months. This event is a reminder that unpredictable shocks can and will happen without warning. History provides no shortage of examples: 9/11, the global financial crisis, and COVID‑19. We strongly believe that events like these are not consistently predictable ahead of time. The more important investment question is not whether we can forecast the next shock, but which businesses are fragile enough to be badly damaged when a shock arrives. Excessive leverage, concentrated supply chains, dependence on a single geography, or other structural weaknesses can turn a surprise event into permanent impairment.

Resilience Through Inversion

We believe it is virtually impossible to predict which risk will materialize next or when. Rather than trying to forecast specific threats, we focus on avoiding fragility.

The late Vice Chairman of Berkshire Hathaway, Charlie Munger, often said that inversion was one of the most powerful thinking tools available. So instead of asking, “How do we minimize risk?” we find it useful to ask the opposite: “How would wemaximizerisk?” If we wanted to maximize risk, we would own businesses that are:

• Burdened with extreme amounts of financial leverage
• Unprofitable, with no foreseeable path to profitability
• Lacking any discernible competitive moat
• Led by dishonest or incompetent leaders
• Excessively popular and highly priced, with no attention paid to valuation

By systematically avoiding these characteristics, we take a critical first step toward risk mitigation – but avoidance is just the start. Our investment process is designed to identify resilient businesses and avoid situations where multiple forms of fragility are layered on top of one another. This is evident in our “three‑legged stool” criteria that we use to evaluate every investment decision: business, management, and price.

We seek companies with durable competitive advantages that we understand and believe are sustainable for many years. Advantaged businesses, while not immune to disruption, have more time and flexibility to adapt as the world changes around them.

We insist on exceptional, honest leadership – CEOs who think about the firm’s capital as if it were their own. This ownership mindset often leads to leaders who anticipate change, refuse to be complacent, and position their companies to adapt and thrive through disruption rather than be consumed by it.

We demand attractive valuations, thinking and acting as if we were acquiring the entire business permanently. We attempt to build in a margin of safety in each investment (a price well below our assessment of intrinsic value). This helps to cushion against the risks we cannot foresee.

Preparing Portfolios to Withstand Risk

Risk can never be eliminated entirely. Some level of risk must be accepted in order to generate attractive long-term returns and meet your investment goals. But the large mistakes – the permanent losses of capital – tend to come not from a single isolated weakness, but from the stacking of multiple risks. Our investment process is designed specifically to avoid this.

The events of this quarter remind us that risk is always present, takes many forms, and most often arrives as a surprise. As Morgan Housel wrote in his bookSame as Ever, “The biggest risk is always what no one sees coming, because if no one sees it coming, no one’s prepared for it; and if no one’s prepared for it, its damage will be amplified when it arrives.” Our aim is not to predict which risks will emerge next, but to ensure your portfolio is built to withstand them. That means studying businesses, not stock charts; focusing on intrinsic value, not short-term price movements; and avoiding fragility wherever we find it.

Thank you for your continued trust. We strive to put forth our best efforts to help you achieve your investment goals each and every day.